Welcome back to our blog series on business valuations. In each post we explore a fundamental valuation topic to help you better understand the steps we take to appraise your business.

Most professionals will mention using an “EDBITDA multiplier” as a tool for determining the value of a business. Let’s break that down.

EBITDA is short form for Earnings Before Interest, Taxes, Depreciation, and Amortization. This amount is a measure for the raw earnings an investor can expect from the operation in any given period. A multiplier is determined based on several of external factors (interest rates, market factors, political environment included) and applied to that EBITDA basis. We will dive into this in a later post.

That said, EBITDA alone is not necessarily representative of earnings (or cashflow) an investor can expect to yield from a business. We need to take a deeper look into each income and expense line on the books and consider whether any are transacted at an amount not reflective of market conditions. Adjustments thereon are called “normalizing” items to determine normalized EBITDA. This is the basis a multiplier will ultimately be applied to in practice.

The objective here is to arrive at an earnings figure that accurately represents the results from the core business operation from the perspective of an investor. There are several normalizing items we might consider in the valuation of a smaller private company:

1. Management compensation

Owner operator compensation is often set to achieve personal and corporate tax planning objectives and not necessarily based on their actual inputs. In their absence, an investor will need to employ a management-type role to handle the functions previously manned by the seller(s).

The normalizing adjustments for management compensation are generally an “add back” of the seller’s wages (if any) and a deduction for replacement fair market wages for a manager. This may have a positive or negative impact on the valuation result depending on how the seller’s wages compared to the market rate.

2. Occupancy costs

Rent and other occupancy costs in the initial EBITDA calculation may require a normalizing adjustment where the business is in a long-term favourable lease or if the landlord is a related party. Commercial leases will generally have a clause to trigger a renegotiation of the agreement in the event the tenant company is sold to a new shareholder. Similarly, if the commercial site is owned by the seller or a party non-arm’s length to them, a negotiation for a formal lease will be necessary.

In either case, an assessment for the market value rent is required for the buyer to understand what the occupancy costs may be under their ownership. The normalizing adjustment will modify the occupancy expense line to meet market conditions.

3. Discretionary expenses

There are typically several discretionary expenses on the books for a smaller privately owned business. These may be personal expenses (think travel, vehicles, entertainment), donations and sponsorships or wages to family members. To be considered discretionary, a valuator must consider whether they are essential to the core operation and have a path to generating revenue.

Adding these back to determine normalized earnings will increase the valuation result.

4. Extraordinary items

The unadjusted earnings can also include a host of extraordinary items that require add back or removal. These may be “one off” transactions or amounts related to redundant assets.

There are several one-off transactions a valuator may suggest be “normalized” out of the EBITDA figure. A few examples are:

a. Revenues from a non-recurring customer
b. Insurance proceeds
c. Non-routine professional fees for a legal dispute
d. Gain or loss on the sale of assets
e. Bonuses to staff or shareholders

Normalization for income or expenses related to redundant assets may also be required depending on the proposed deal structure. If an investment portfolio has accumulated in a business and the intention is to remove it ahead of a sale, then investment income and any related expenses should be omitted.

These are a few common normalizing adjustments that might be considered in a valuation report. The real application of this practice is of course more broad and can vary depending on the size of a business and the industry it operates in.

For assistance in understanding the value of your business or one you are interested in purchasing, we recommend connecting with a local valuation professional.

 

Written by: Curtis Reeve, CPA

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