Normalization Adjustments Are NOT Just Personal Expenses

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At a recent conference, I presented on what is considered a normalization or EBITDA adjustment.

This presentation, which you can watch a version of here, was all about increasing the enterprise value of your company when it comes time to sell.  And no, it’s not based on your net income or even your EBITDA, but your normalized or adjusted EBITDA, which undoubtedly will increase the value of your company. Unfortunately, most sellers don’t know this and can leave lots of money on the table.  But that’s not going to be you after you read the rest of this blog.

First, let’s get the definition of “normalization” out of the way. Normalization adjustments are the adjustments that you will make to your net income (either increase or decrease) that remove all the non-essential, one-time, or personal expenses that you run through the company that won’t happen post-sale.

Notice how I didn’t just say personal expenses?

This is a common misunderstanding with business owners who are preparing their company for a sale.  They assume that they just need to remove all the personal expenses that they run through the business, and that’s that!  In reality, there are actually a number of items that need to be looked at to really come up with a thorough list of adjustments. Again, all in the effort of increasing your enterprise value.

Remember, every dollar you find here is multiplied by the multiple you sell for.  So, for example, if you find $300K of adjustments over the last twelve months and the typical multiple for your size company is 6x, then you just added ($300 x 6x = $1,800,000) to your sale price.  Worth the effort, don’t you think? 

After having worked on dozens of seller financials, I have devised my own system for uncovering normalizations so that none get missed. And now, I am sharing these with you.

8 Common Categories of Normalization Adjustments

Below you can see 8 categories of typical adjustments I look for when reviewing my client’s financials. 

Let’s take a brief look at each one:

1. Personal Expenses:  These expenses, such as cell phones, cars, boats, and other toys, along with personal travel and entertainment, I see on 90% of all financials. This category includes children on the company payroll who might help out now and then (or the parents just run their allowance through the books). Personal home expenses like internet or home office expenses might be included here as well.
2. One-Time or Other Business Expenses:  This includes items that may only happen once, like a large discretionary bonus or an unusual legal fee for redrafting your agreements (since you haven’t done that in the last 10 years). It might also include other business expenses that you don’t plan on maintaining, like professional groups or associations.  Here is usually where I see large one-time expenses for recruitment or peer groups that won’t be continued.
3. Salary Adjustment and Payroll Taxes: Rarely do I see owners paying themselves market rate.  It is usually under, but sometimes excessive.  In either case, the salary needs to be adjusted up or down to meet current market rates.  This should also include the payroll taxes like FICA, or any other state taxes associated with payroll that the employer would pay.
4. Sale of Assets: Very often, owners sell assets (not to be confused with inventory) in the company.  Common asset sales are cars, computers, etc.  So, there will either be a gain or loss, which either needs to be subtracted or added back to net income.

1. Extraordinary Gain/Loss and PPP Loans: Extraordinary gains or losses are most commonly due to two things, but can be other items as well.  The first most common is the PPP loans back from 2021 or 2022 that were forgiven.  The second would be proceeds or payments of a lawsuit. Gain or loss might also be due to a sale of investment assets or other commercial paper.
2. Mistakes:  This is the mostmissed or overlooked adjustment of all.  Every business owner, at some point, makes a decision that just doesn’t work out.  That might be a new SEO marketing program, or a new recruiter, or a new hire for a new position that ultimately is not needed, or the person doesn’t fit the role.  I call these “mistakes,” and they can be added back to net income in some circumstances.  These typically are larger and can be easily noticed in the financials. Another common one in this area is starting a project with a customer where it is not a good fit, and having to incur a large write-off due to fit or other circumstances.  These adjustments just need to be well documented to be accepted by the buyer.
3. Acquisitions or Divestitures of Lines of Business: Whether an owner buys a business or sells part of their business, this event must be reflected in the P&L, either on a go-forward or backward-looking basis. For example, if you purchased a company, and part of the purchase requires you to pay out for an earn-out, this “expense” can be instead treated as a liability or reduction thereof as a normalization adjustment.  This can get complicated, so make sure you consult with a CPA.
4. COVID-Related Expenses: While COVID is long gone, the effects on the P&L still remain, as owners need to show the last three years of P&L activity as part of their financial due diligence. Expenses incurred specifically due to COVID are all common add-backs, such as costs incurred to allow people to work remotely, or rent abatement that might have been in effect during a certain period of time, or extra software required to allow people to operate remotely.

Conclusion

Most companies over $5M in revenue can amass a good amount of these expenses and, on average, I typically find a dozen or more adjustments over the current year and preceding three years.  This usually amounts to well over $250K in adjustments on average, if not more…which, as I explained above, can really add up to a substantial increase in enterprise value. 

Therefore, take the time (especially if you are not using an M&A advisor) to really look long and hard, because usually this is where sellers leave money on the table.  If you are still uncomfortable and feel like there is a substantial amount sitting in your P&L, then you might consider getting a Quality of Earnings report done in advance of going to market to determine your true adjusted EBITDA.

Want to learn more about this topic?  Be sure to watch the replay of my presentation, Increase Your Asking Price: 4 Proven Strategies to Sell Your IT Company for More. It’s a quick 30 minute video, worth every minute.