Common Normalization Adjustments in Valuations of Closely Held Companies

BY CONNOR BRENNAN AND BRYAN ENDRES

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The preceding article was prepared by its author. The opinions expressed in the article represent the author’s and may not reflect the view and/or opinion of Vallit Advisors and its staff. Views/opinions are based on the specific facts and circumstances of each Matter.

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Connor Brennan is an analyst at Vallit Advisors, LLC primarily focusing on providing dispute advisory, business valuation, and forensic accounting services for our clients. Mr. Brennan can be reached at 443-699-6412 Ext 115 or cbrennan@vallitadvisors.com

Bryan Endres is a senior analyst at Vallit Advisors, LLC and primarily focuses on providing dispute advisory, business valuation, and forensic accounting services for our clients. He has written an article in a professional and peer reviewed journal covering valuation topics. Mr. Endres can be reached at 443-482-9500 Ext 108 or bendres@vallitadvisors.com

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COMMON NORMALIZATION ADJUSTMENTS IN VALUATIONS OF CLOSELY HELD COMPANIES — IN MOST VALUATIONS OF CLOSELY-HELD COMPANIES (“COMPANIES”), ANALYSES ARE PERFORMED ON A NON-CONTROLLING OR CONTROLLING BASIS AND UNDER EITHER THE FAIR VALUE (“FV”) OR FAIR MARKET VALUE (“FMV”) STANDARDS. COMPANIES’ FINANCIAL STATEMENTS FREQUENTLY INCLUDE ACTIVITY THAT DOES NOT ACCURATELY ALIGN WITH THESE PARAMETERS, WITHOUT ADJUSTMENTS. FURTHER, FINANCIAL STATEMENTS MAY NOT REFLECT THE NORMALIZED, ONGOING EXPECTED PERFORMANCE OF THE COMPANY. AS A RESULT, NORMALIZATION ADJUSTMENTS ARE TYPICALLY NECESSARY TO ENSURE THE FINANCIAL STATEMENTS ACCURATELY REFLECT THE COMPANY’S ONGOING PERFORMANCE. THIS DISCUSSION (1) DEFINES NORMALIZATION ADJUSTMENTS, (2) DETAILS THE CONSIDERATIONS INVOLVED FOR MAKING NORMALIZATION ADJUSTMENTS, (3) DESCRIBES THE EFFECTS OF NORMALIZATION ADJUSTMENTS ON EACH VALUATION APPROACH, AND (4) SUMMARIZES COMMON EXAMPLES FOUND IN VALUATIONS OF COMPANIES.

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Introduction

Adjusting the financial statements of a company is a unique process to the business valuation profession. Valuing a closely held company (i.e., a business that is privately owned and not publicly traded), requires more than just analyzing the financial statements provided.

Unlike public companies, who are subject to strict regulatory oversight and consistent reporting standards, closely held firms often reflect personal, non-recurring, or discretionary items within their financial statements. Adjustments made to these items are essential to reflect the true economic performance of the company.

The main objective of a business valuation is to present a reliable and unbiased estimate of a company’s value. This can partly be achieved through normalization adjustments defined as the adjustments made to the historical financial statements of a company.

Normalization adjustments help to ensure the reliability of the valuation by adjusting the historical financial information for any anomalies that may distort the company’s true ongoing operations. Such items commonly adjusted may include, but are not limited to, owners’ compensation, related party transactions, non-recurring or unusual items, discretionary expenses, depreciation and amortization adjustments, non-operating assets and income, and tax adjustments.

Through the process of recognizing and applying these common normalization adjustments, the business valuation can present a more accurate and clear picture of a company’s earning capacity and risk profile. These adjustments not only improve the company’s comparability to industry benchmarks, but they also provide stakeholders with a meaningful basis for decision-making, whether in the context of litigation, tax compliance, financial reporting, or transaction planning.

 

Considerations Preceding Normalization Adjustments

Premise of Value

In business valuation, premises of value refer to the underlying assumptions about how a business will be used or disposed of in the future, which directly influences the valuation conclusion. In business valuation, the “going concern” and “liquidation” premises are the most common premises applied.

The going concern premise assumes the business will continue operating into the future as it has in the past, allowing it to generate revenue and profits over time. Valuations performed under this premise typically focus on the company’s earning potential, often using valuation methods such as the capitalization of cash flow (“CCF”) method or merger and acquisition (“M&A”) method. This premise is appropriate when the business is financially stable or expected to recover (or improve), and its assets are used productively in operations.

In contrast, the liquidation premise assumes the business will cease operations and its assets will be sold off, either in an orderly or forced manner. In this instance, the valuation is based on the net realizable value of assets after settling liabilities and deducting selling or liquidation costs. This premise may be used when a company is insolvent, shutting down, or undergoing bankruptcy.

Financial statement normalization adjustments (at least related to the income statement) are more common in valuations performed under the going concern premise. In this article, we will be discussing the valuation of companies under the going concern premise of value.

 

Fair Value vs. Fair Market Value

In business valuation, the terms fair market value (“FMV”) and fair value (“FV”) represent two distinct standards that can lead to different valuation conclusions for the same company depending on the context in which they are applied.

FMV is commonly defined as the price at which a business or asset would exchange hands between a willing buyer and a willing seller, both acting knowledgeably, prudently, and without compulsion, in an open and competitive market. It reflects real-world market conditions and typically includes discounts for factors such as lack of marketability (a “DLOM”) or lack of control (a “DLOC”), where applicable. FMV is commonly used in tax-related valuations, such as for estate and gift tax purposes, marital dissolution valuations, as well as in general buy-sell transactions.

FV, on the other hand, is a standard often applied in financial reporting and some legal contexts, such as shareholder disputes or dissenting shareholder actions. Its definition can vary depending on the applicable accounting framework (like U.S. GAAP or IFRS) or statutory law in specific jurisdictions. Unlike FMV, FV often excludes certain discounts in order to reflect a more “equitable” value between parties. Many times, FV is defined as FMV excluding the application of DLOC and DLOM.

Based on the standard applied, a valuation analyst will have to consider whether a DLOM and/or DLOC are applied. The normalization adjustments made to the historical financial statements may also differ whether the interest being valued is on a controlling basis vs. a non-controlling basis and a marketable vs. non-marketable basis.

 

Controlling vs. Non-Controlling and Marketable vs. Non-Marketable

In business valuation, an important consideration is whether the valuation is conducted on a controlling vs. non-controlling basis and a marketable vs. non-marketable basis. These distinctions influence both the value conclusion and the types of discounts or premiums applied.

A controlling interest refers to ownership that provides the ability to direct key business decisions—such as setting strategic direction, controlling cash flow, determining management compensation, and initiating a sale or merger. A non-controlling (minority) interest, by contrast, lacks such authority and is subject to the decisions of controlling shareholders. As a result, non-controlling interests are typically valued lower per share than controlling interests, and a DLOC may be applied to reflect this reduced influence.

Similarly, a marketable interest assumes the ownership interest can be readily sold or converted to cash in a public or active private market. A non-marketable interest reflects holdings in privately held companies or restricted shares, where liquidity is limited or nonexistent. Since selling these interests is more difficult and time-consuming, a DLOM is often applied.

When valuing a non-controlling interest, an analyst can take one of two approaches: The analyst can either (1) base the valuation directly on the company’s non-controlling-level cash flows, or (2) adjust the company’s cash flows to reflect a controlling interest and then apply a DLOC. To convert the company’s cash flows to a controlling basis, the analyst must apply control adjustments to the company’s historical financial statements.

That is to say, valuation analysts typically agree that the effect of control or non-control can be measured in either the company’s cash flows or through the application of a DLOC.

A valuation analyst should be aware of the impact that control and marketability have on a valuation. For purposes of this article, a full discussion of DLOC and DLOM are outside the scope of this topic. All normalization adjustments discussed in this article will be discussed related to the controlling, marketable level of value for a subject company. When control level adjustments are not made, cash flow is on a non-controlling basis. In this instance, application of a DLOC would not be applicable.

 

Impact on Valuation Approaches

It is essential to understand the way that normalization adjustments impact the conclusions reached within a valuation. Normalization adjustments impact on valuation varies depending on the approach (income, market, and asset) applied. The impact of normalization adjustments on the three primary approaches are summarized below.

 

Impact on the Income Approach

Normalization adjustments often have a direct and significant impact on a valuation performed under the income approach. This is because the income approach relies heavily on the company’s ability to generate sustainable cash flows into the future. Adjustments to the income statement are some of the most common normalization measures in a valuation as they ensure that reported earnings are accurately represented and indicate the ongoing economic performance of the business. These adjustments normalize the company’s cash flow to reflect a more accurate indication of value under this approach.

 

Impact on the Market Approach

As previously mentioned, the adjustment of a company’s financial statements is critical to ensure that the company’s financial results are indicative of true economic performance. These adjustments allow for these companies to be compared to similar guideline public companies (“GPC’s”) or transactions involving similar private companies (i.e., M&A’s) under the market approach. It is assumed these same adjustments are made to the GPC’s and M&A’s financial data. The primary effect that normalization adjustments have on the market approach is the comparability of financial performance and the valuation multiples selected.

 

Impact on the Asset Approach

Adjustments made to the balance sheet can have a great influence on the value indicated under the asset approach. Normalization adjustments made on the balance sheet provide a clearer picture of the net asset value of the company, ensuring that the recorded assets and liabilities reflect what would be reasonably expected in an open market. This makes the asset approach a more reliable indicator of value, especially in scenarios where earnings-based methods are less applicable.

Sometimes the asset approach is misconstrued as liquidation value. However, the underlying theory is the principle of substitution. A potential buyer would invest in a similar composition of assets and liabilities as the company being valued.

Next we’ll discuss some of the more common normalization adjustments that valuation analysts make to company financial statements.

 

Owners’ Compensation Adjustment

The adjustment to owners’ compensation is often a crucial adjustment made in many valuations of companies. Owners’ are often compensated in one of two ways: compensation paid through the entity (i.e., owners’ salary, bonuses, etc.) or through equity distributions. Distributions are typically paid based on the company’s profits.

This adjustment is common as owners of smaller companies often pay themselves salaries that are not reflective of the market rates for comparable positions. There are two common instances where an owner’s compensation adjustment may be necessary. The first is when the compensation is above market rate, often to reduce the businesses’ taxable income. The second is when the compensation is below market rate. Owners may under compensate themselves to retain more earnings within the business or if the company simply can’t afford to pay them a market rate of compensation.

The under/over compensation of owners will either serve to positively or negatively impact the company’s cash flows, in turn impacting the ability of the company to make distributions to the owner. Distributions represent both a return on and a return of their investment in the company. Investors often look for companies with high amounts of distributions as it suggests the company is generating more cash than it needs to fund its operations and growth, meaning equity distributions and a return on their investment may be more likely.

 

Adjustment Rationale

The normalization of owners’ compensation can be thought of as what a non-owner would be compensated for the same role in the open market. It is important to take into consideration the owner’s level of experience, contribution to the business, and knowledge of the industry. Taking these factors into account and researching compensation for similar roles in the industry can result in a necessary adjustment. Depending on whether the compensation is under or overstated, an adjustment can be made to bring the owners’ compensation to a normalized market level, in turn contributing to the normalization of the businesses’ cash flows.

It is also important to recognize how the company’s tax structure can influence the reported amounts of owner compensation. Compensation is often overstated in C-Corporations (“C-Corps”) as the owners of C-Corps may prefer to take larger salaries and bonuses rather than receiving dividends taxed at the C-Corp level. This is because C-Corp owners are “double taxed” at both the entity level (i.e., corporate income tax) and the owner level (i.e., income tax on dividend income).

Conversely, in S-Corporations (“S-Corps”) or other pass-through entities (e.g., limited liability companies or “LLCs” and more), it may be more likely that owners’ compensation will be understated. Owners may reduce their reported compensation by electing instead to take distributions, which are not subject to payroll taxes. Because S-Corps and other pass-through entities often do not pay entity level income taxes (instead “passing through” all income to owners), the dividends or distributions from these entities avoid the C-Corp double tax issue. These incentives distort the compensation relative to market values, making the normalization adjustment necessary to reflect what a third party would reasonably pay for the same role.

Additionally, it is important to note that this adjustment is considered a controlling adjustment. That is, when a valuation analyst is valuing a non-controlling interest (i.e., using a non-controlling cash flow), the analyst may opt to not make such an adjustment. In these cases, the non-controlling interest cannot stop the controlling interest owner from say, overpaying themselves, which all else being equal, reduces the cash flows available to the non-controlling owner. Because both FMV and FV valuations contemplate the price to be paid for the subject interest between market participants, the rationale is that the buyer and seller would value such a non-controlling interest knowing that cash flows may be lower because of this owner over-compensation.

 

Example

A common practice in divorce matters is for the business-owning spouse to reduce compensation in the event of a divorce. This is to reduce the amount of taxable income they generate, effectively reducing the amount of alimony and/or child support owed to the spouse. In these cases, the business-owning spouse might pay themselves below market level compensation through the entity, overstating the net income, and understating their personal income. A hypothetical willing buyer of the company would expect to have to pay the expenses forgone by the business-owning spouse taking less compensation. That is, as an investor, if the buyer were to “buy out” the owner spouse, the services that the owner spouse provided the company (say, as the CEO) would need to be replaced. Valuations typically assume that a non-owning (i.e., employee) CEO would have to be hired and paid a market rate to perform those services. Therefore, an adjustment would be made to increase owner compensation for the business-owning spouse to a FMV level.

The same principle applies when an owner is paying themselves above-market level compensation. For example, a lawn service company in Annapolis, Maryland generates $1,000,000 each year in revenue. The CEO of the company compensates themselves $250,000 per year. After researching the market compensation for lawn service companies in the area, CEO’s in this industry with $1,000,000 in annual revenue are paid $200,000. In this scenario the owner is paying themselves $50,000 above FMV levels. As such, a downward normalization adjustment to owner’s compensation would be made, increasing the profitability of the company to a normalized level.

 

Related-Party Transactions

An adjustment to normalize related party transactions is another commonly seen adjustment when valuing companies. They may have transactions with owners, family members, or affiliated entities that do not occur at a FMV level. We can observe these transactions on both the balance sheet as well as the income statement. Some examples of these transactions can include above or below market rents, personal expenses run through the business, and intercompany loans with terms that do not reflect typical loan agreements. Through the adjustment of these transactions we can more accurately reflect the value of the business in terms of an open market.

 

Adjustment Rationale

Transactions made through related parties are common in small to mid-size closely-held businesses and often include favorable terms for the related party. It is not reasonable to expect that if the business were to change hands these terms would be reflected in future transactions. Making these adjustments ensures that the company’s financial statements are free of distortions and better represent the sustainable economic performance of the business. Unless there is a legal document in place that would mandate a future non-market transaction.

It is important to note that this adjustment is a controlling adjustment and as such may not be applied if the company is being valued on a non-controlling basis using non-controlling cash flows, as previously discussed.

 

Example

As mentioned above, one common related party transaction is rent. It is common for an owner of an operating company to purchase the real estate of the business and form a LLC to hold the property. The operating entity would then pay rent to the newly formed LLC. Typically the primary reason is to separate the risk of the real estate being attached to potential litigation of the operating entity. When valuing the operating company, the reduced/excess rent paid under/over FMV levels would be adjusted on/off the income statement to present a normalized level of rent expense.

 

Non-Recurring Income or Expenses

Non-recurring refers to unusual, infrequent, or one time income or expenses that are not representative of the businesses’ ongoing operations. A few common examples of these include a gain or loss from the sale of an asset, paycheck protection program (“PPP”) loan forgiveness, and litigation settlements. Nonrecurring income and expenses vary on the impact to a business’s profitability depending on the dollar amount; however, these items can often be large factors in overstated or understated net income.

 

Adjustment Rationale

Business valuation is a forward-looking process, meaning that we want to reflect income and expenses that accurately portray the operations of the company well into the foreseeable future. It is not reasonable to assume that these items will be reflected in future years of the company’s operation. The most common adjustment to these items is to remove them from the financial statements.

 

Example

A common example of non-recurring income occurred in 2020. As part of the U.S. government’s response to the Covid-19 pandemic, it passed the CARES Act. In that Act, the government offered loans administered by the SBA to businesses at 1.0 percent interest rates. These loans were designed to be forgiven if the business entity used the proceeds towards qualified expenses, mainly payroll. With the majority of these loans being forgiven, businesses were then able to record these loan proceeds as income. It is doubtful that we will ever see a program like this again, and as such a hypothetical willing buyer and seller cannot expect to receive this income going forward.

 

Discretionary Expenses

Like non-recurring expenses, discretionary expenses are not reflective of the costs necessary for the companies’ operations. These expenses are often at the discretion of the owner and may be personal or lifestyle-related in nature. Some common examples seen with these smaller companies include non-business-related travel and entertainment, personal automobile expenses, club memberships, and charitable contributions.

 

Adjustment Rationale

Since these expenses are incurred at the discretion of the owner it would not be reasonable to expect that these expenses would continue if the business were to change hands. Through the removal of discretionary expenses, the company’s financials more accurately reflect the ordinary and necessary expenses of a business. Removing these expenses helps to normalize earnings measures such as earnings before interest, taxes, depreciation and amortization (“EBITDA”) or net income as well as improving the company’s comparability to peers in the same industry. Business valuation professionals remove discretionary expenses to provide a more dependable and defendable estimate of worth that is in line with industry statistics and what a buyer would anticipate on the open market.

Discretionary adjustments may be controlling in nature and should consider the non-controlling vs. controlling cash flow issues previously mentioned.

 

Example

Discretionary expenses, in essence, involve expenses not mandatory for the business to continue operations. For example, if a prospective buyer was to review the expenses of a pizza restaurant in Manhattan, the buyer would expect to see expenses for pizza ingredients, marketing, rent, etc. If the owner of the pizza restaurant also had expenses for a country club membership in New Jersey and travel expenses to Europe in the amount of $10,000 annually, the prospective buyer would not purchase the company and continue to pay for these expenses. The membership and travel expenses are discretionary to the current owner of the pizzeria and not mandatory for the continued operation of the business. As a result, these discretionary items would be removed from the income statement to present a normalized level of operations consistent with other pizzerias in the industry.

 

Depreciation and Amortization

Depreciation and amortization adjustments are an important part of normalization as tax-driven accounting elections can distort the economic impact of an asset’s usage. A great example of this comes from accelerated or front-loaded depreciation allowable by way of Section 179 of the Internal Revenue Code. This deduction allows the company to depreciate the full cost of a qualifying asset in the year that it is placed into service. Certain accounting elections for the amortization of intangible assets may require adjustments as well since they may not reflect the true economic benefit of the intangible asset.

 

Adjustment Rationale

While beneficial for tax purposes, accelerated depreciation or arbitrary amortization periods are often not indicative of the useful life of a business’s tangible and intangible assets. Normalization is necessary to represent a reasonable and consistent expense for the replacement of fixed assets and consumption of intangibles. These adjustments allow for the normalization of the businesses earnings, providing a better representation of the economics of the business.

 

Example

One way depreciation impacts cash flow is through Section 179 depreciation. For example, if a business bought a tractor for $50,000 in the prior fiscal year and elected to fully expense it under Section 179, it would record $50,000 in depreciation that year. As a result, no further depreciation would be recorded for that asset in the current or future years, even though the tractor still has a remaining useful life.

On the balance sheet, the tractor’s book value would be reduced to $0, with the full $50,000 shown as accumulated depreciation. However, in practical terms, the tractor still holds value and will likely be in service for 7 to 12 years. To more accurately reflect this ongoing value, a normalization adjustment to depreciation would be made based on the economic useful life of the asset. Depreciation would then be captured over the life of the asset, normalizing the business’s after-tax cash flows.

These types of adjustments improve the economic substance of the financial statements and get them closer to GAAP prior to applying the approaches to value.

 

 

Non-Operating Assets and Liabilities

When valuing a company, it’s essential to distinguish between operating and non-operating components of the business to arrive at a more accurate assessment of its core value. Non-operating assets and income represent items that are not essential to a company’s core business operations but still appear on its financial statements. By isolating non-operating elements, analysts can better evaluate the value generated solely by the company’s core business activities, leading to a clearer picture of enterprise value and more meaningful comparisons across companies. A few common examples of non-operating assets and income include personal automobiles, vacant land, and income from investments unrelated to the company’s activities. Any impact on the profit and loss statement related to the non-operating assets and liabilities should be eliminated.

 

Adjustment Rationale

Since the income generated from these items does not directly contribute to the generation of operating cash flows for the business, they must be excluded from normalized earnings. It is important to note that these items are often added back to the concluded enterprise value. This ensures that the valuation reflects the true earning capacity of the company’s operations while still accounting for the value of the extraneous assets or income sources.

 

Example

A good example of a non-operating asset is a personal automobile. Personal automobiles do not contribute to the ongoing operations of the company but rather provide benefits solely to the owner. As such, the personal automobile would be considered a non-operating asset. A non-operating asset would be removed along with any expenses associated with the asset. Expenses for a personal automobile would include gas, repairs, auto insurance, and any other expenses attributable directly to the personal automobile. By removing the non-operating asset, and the associated expenses, we remove the consideration of this asset from the three approaches (asset, market, and income) when developing the enterprise value. The value of the personal automobile will then be added back to the enterprise value since it remains an asset owned by the company, even if it is not required for ongoing business operations.

 

Tax Adjustments

When conducting a valuation using an income approach method (such as the CCF method) a normalized tax rate is applied to estimate the company’s sustainable, long-term tax burden. It typically represents the combined federal and state corporate tax rate applicable to a C-Corp. As a result of the development of capitalization rates and discounts in other components of the valuation which is based on publicly traded C-Corps.

When valuing pass-through entities such as LLCs or S-Corps, valuation analysts will typically still apply the C-Corp tax rates to their earnings, even though these entities are not directly subject to these tax rates. The primary rationale behind this is often the cost of capital data, market approach data, and other industry data often used by valuation analysts is sourced from public C-Corps who pay such income taxes. To ensure that the valuation is performed on an “apples-to-apples” basis, tax-affecting pass-through entity income at C-Corp tax rates ensures that the valuation is internally consistent.¹

As a result, historical income taxes reported on the company’s financial statements are excluded from the analysis, ensuring that future cash flows are evaluated on a consistent and normalized after-tax basis.

As noted above, the income tax expense reported in a company’s historical financial statements may be influenced by one-time items such as tax benefits, penalties, or the use of loss carryforwards. These factors can distort the company’s true, ongoing tax burden. Therefore, historical income taxes are removed from the financials, and a normalized tax rate is applied to the company’s adjusted earnings before taxes (“EBT”) to more accurately reflect sustainable after-tax performance.

 

Conclusion

For closely held businesses, normalization adjustments are essential to produce a reasonable and credible estimate of value. These adjustments remove distortions—such as those discussed in this article—and result in financial statements that better reflect the company’s foreseeable earning potential.

In addition to enhancing comparability with industry peers, normalization provides stakeholders with confidence that the valuation is grounded in economic reality, not temporary or unusual events. Whether applied under the income, market, or asset approach, normalization ensures the valuation accurately represents the company’s economic performance and serves as a reliable foundation for financial planning, litigation, and transaction-related decisions.

 

 

References

¹ Alternatively, analyses can be done on a pre-tax basis, but this would require developing pretax discount rates and the data valuators usually rely on are from public C-Corps that pay corporate taxes.