Mr. Jackson is the CEO and sole owner of Get Rich Records, a music recording studio. Mr. Jackson considers himself to be well-versed in the industry and recently read in a trade magazine that the market for recording studios is hot. The article stated that other studios have recently sold for as high as four times EBITDA. At the end of 2018, Mr. Jackson picks up a copy of the company’s audited financial statements. He sees a cool $1 million of EBITDA on 2018’s income statement. Mr. Jackson calls his mom to express his delight that his company is worth $4 million. Mr. Jackson assumes that assessment of his company’s value must be accurate since it is based on audited financial statements.
While the financial statements may be correct, or materially presented in accordance with GAAP, they may not be reflective of the company’s true economics. It is easy to take historical financial statements at face value, however, they may prove to be an inexact measurement of business operations when attempting to determine value. Financial statements often need to be adjusted to reflect the ongoing operations of the business for a hypothetical buyer. In the land of valuation, these adjustments are called normalizing adjustments. We explore a few common areas where valuators often find normalizing adjustments to help in the pursuit of a conclusion of value.
Items of revenue or expense that will not be recurring in the future are candidates to be removed out of the historical financial statements with a normalizing adjustment.
Gain/Loss on Sale of Assets
Get Rich Records sold some sound equipment for a gain of $150,000 in 2018. Get Rich is not in the business of selling sound equipment, and this is a rare occurrence for the company. Since this income will not be reliably recurring in future years, the $150,000 gain is subtracted out to get to normalized income.
Mr. Jackson had some ongoing litigation throughout 2018 that resulted in a legal bill paid by Get Rich in the amount of $85,000. This litigation was resolved in November and will no longer be ongoing. This expense must be added back to the 2018 income statement.
Get Rich moved into a fresh space in order to rejuvenate the employees and make some significant amenities upgrades. The rejuvenation cost the company nearly $60,000 in moving expenses. After the move, Mr. Jackson expressed his relief that the massive undertaking was complete and vowed to not move the company again in his lifetime. The expenses associated with moving need to be removed from the income statement in order to normalize earnings.
Expenses that are paid at the discretion of the owners/officers and do not need to be incurred in order to operate the business are also fall victim to normalizing adjustments.
Compensation of Owners and Family Members
Mr. Jackson is supremely confident in his abilities and believes his market value as a CEO is a half a million dollar annual salary. If a prospective buyer were to acquire Get Rich Records, they could bring in a CEO and pay him or her $250,000 based on a compensation study. A downward adjustment of $250,000 to officer compensation needs to be implemented to get to normalized income.
As the sole owner, Mr. Jackson has included his cell phone, car, and some lavish entertainment expenses (many steak dinners and front row seats at sporting events) totaling $55,000 annually on the books of Get Rich. These expenses are considered discretionary and not necessary to operate the business. These expenses are removed from the income statement in order to normalize income.
So, it may not be as simple for Mr. Jackson as picking up the audited financials and slapping a multiple on the EBITDA number that he sees. A deeper dive into the income statement is often necessary to search for normalizing adjustments. Once the normalizing adjustments have been made, Mr. Jackson will have a much clearer picture on the value of his recording studio to a prospective buyer. He may even be able to get rich.