EP43 - Norm! Normalization adjustments for business valuation of ESOPs

Good Afternoon, everybody. This is the ESOP guy, and we are on a journey to an ESOP. So, if you're joining for the first time today, I just wanted to say thank you and, and welcome to the podcast. If you have an interest in other episodes of this podcast, please go to our website at journey to an ESOP.com. And for those that are continuing on this journey, I just wanted to say thank you and we're gonna start off today with this. Good afternoon everybody. Oh How you doing? What do you know? Not enough. Have baby. Norman. You know, I heard of that stuff. I give me a tall one in case I like it. Yeah Norman? I don't know. Cut the small talk and give me a beer. Hey If you don't recognize that, that is the famous norm from a famous TV show that we should all be um at least aware of, which is Cheers, and I'm titling this podcast in honor of Norm, and it's gonna be titled The New Norm. That is normalizing entries for an ESOP valuation. And the new norm for us now is that we all wear masks everywhere we go. We all sanitize and wash our hands, and I, I've always done that, by the way, and keeping our distance from people and, and that, that's kind of somewhat of the new norm. Um, but when you think about the idea of, of norm and normal, um, what we're we're gonna do is talk a little bit more about Moving that kind of concept into the, an important step in doing a business valuation for an ESOP. And that is when we are looking at maybe the income approach or the market approach, we're going to go through the process of normalizing the financial statements. So, this is one of the areas that when you do business evaluation, what you learn quickly is this impacts the valuation greatly and you're, you're gonna see why as you listen to this podcast, what the effects of normalization entries are. And what, what they're all about and really trying to understand what, what you should be asking as a listener to your advisor about your normalization entries and making sure that you're educated in this area because it's an incredibly important part of business valuation. So if you like what you hear, as always, please subscribe to the podcast and it really might be helpful to someone that you know, so please share it with a friend. And if you can rate and review the podcast, it's very helpful as a resource that others might be considering to look at or listen to for their own education. Now, when you think of a powerful figure. Fictional or non-fictional? People that you would say, hey, effect change. Uh, the norm in Cheers, it doesn't actually resonate, does it? He's affable. He's, he's someone that you would like to have you buy you a beer, you buy him a beer, um, hang out and just talk about, you know, whatever. Um. it's not, he's not really a matter of, of a person who is changing things. Um, but I wanted to start off this episode with a norm that did change things, and his name is Norman Schwartzkopf, and I wanted to say to, you know, as we honor our military, which I believe is very important, um, as a country, um, that this general Norman Schwartzkopf was, was named as a nicknamed Storm and Norman. And General Norman Soskopf was known for his fiery temper and his keen strategic mind. He graduated from West Point and fought in the Vietnam War. In 1983, he was made a general and several years later became a four-star general and commander of the US Central Command. His career included commanding forces in Granada and the Persian Gulf War. He actually died in Florida in December of 2012. So just to kinda stop and honor Norman Swartzkopf and really, you know, as we look at that, the reason I pulled out Norman Swarzkopf, or general Norman Schwartzkopf is because um when you start thinking about normalization entries, They are very impactful. They are absolutely going to change things and um someone like, uh, a general in our military has that kind of power and so do normalizing entries. So, so I just wanted to connect the dots between Norman and um our beloved, you know, Norm from Cheers, and then, of course, um General Norman Schwarzkopf. A privately held company has its own way, you know, as they do things and it's, and the, and the key thing is you learn in business is that every business that's privately held for the most part is going to be run and the decisions that, that the owner makes absolutely affect the business in a lot of different ways. But when you understand normalization entries at the outset, what I wanted to start saying is, is that most privately held companies are going to have some type of normalization entries, and it's the application of those when you start thinking of business valuations, that matters. And not to get hung up on the idea, but it is important. To understand that as you, as you start thinking about what is a normalization entry, is that um private health companies are successful entity that are successful entities um have the discretion to do what they want with their money and, and how we're accounting for it as a CPA firm. And on their tax records, um, it, it doesn't really matter in, in a sense because, you know, if it's, if it's gonna be a personal distribution, but we're being, we're spending that on a, say a hunting lodge, that money that goes to the company, um, we're, we're taking it out the right way. But ultimately, we, we all know in business that that if I bought that company, I may not need to go hunting, you know, and I'm, and that's just a very extreme example as we, as we start talking about it. What you're going to get out of this podcast is much more detail behind specific normalization entries and an example of how those work in really an example of of how they could affect your business valuation. Normalized financial statements are defined in the international glossary of business valuation terms as financial statements adjusted for non-operating assets and liabilities and or for non-recurring, non-economic or other unusual items to eliminate anomalies and or facilitate a comparison. So, from that definition, what we need to know. is as valuators is really the process of normalization. What does it take to normalize a financial statement in order to estimate future expected cash flows, which ultimately buyers don't buy historical cash flows, by the way, they buy future cash flows because historical cash flows are gone, right? They don't exist, but they're an indicator of future cash flows. So what we want as buyers, though, not we, but maybe the the buyer is to be, to be able to reasonably expect what those cash flows are going to be in the future. For, um, to measure the valuation, but really to measure to the return on their investment. Um, and we look at this, um, on a basis that, so we can compare other companies as well. So it's not just there, we're normalizing just for the sake of normalizing, we're also doing it because we're, we're a lot of times making comparisons when we do business valuations with other entities, particularly publicly traded entities. Um, that have a freely traded type of cash flow related to it. So normal normalizing adjustments, really adjust the income statement of private companies to show a perspective purchaser the return from their operations and reveal the uh an income stream that we're gonna talk about as freely as a freely traded value. And so, one of the areas this comes up in evaluations is if you're using a market approach, and in the case where you would use a guideline public company method, which is taking public company data and extrapolating multiples from that data to compare to your subject company, which is basically means Um, the, the evaluator goes out, finds, um, comparable market data, publicly traded market data for the subject company and because their, their cash flow and because that business is based around uh a, a freely traded uh cash flow, which means it's public stock, people can buy it and sell it at will. Then what we have to do is to make sure that our, our cash flow is normalized to make sure it, it, it is similar in nature. So hopefully that, that makes sense and that's not too, too technical. Now on the income approach, it's the same thing as we build up a capitalization rate, we're using publicly traded data as well. The capitalization rate is, is the key risk rating we use to capitalize earnings and also to to build our discount rates for the discounted cash flow model. And so again, those have to be normalized um to, to the freely traded values of the data that we're getting. So one of the things as we start off understanding the process of normalization is, is asking the right questions. And when you do evaluation work, one of the things you're going to be doing is asking and evaluating um the financial statements or, or, you know, examining the financial statements for questions. And one of the questions you might have is, hey, has there been anything unusual in the business? That has happened in the last 5 years. And so the question is really about understanding the potential for that unusual circumstance to be non-recurring. So as we, as we start to kind of layer out or unload or unpack the, the terminology here, it's really just kind of common sense. If, if something happened in the past, it really is never gonna happen in the future and it cost your company cash flow. then we don't really need to worry about that going in the future. So it's not gonna affect future cash flows. Other questions might be like what are significant changes in your revenue? You're specifically within your cost of goods sold and within your GNA. So, so the key here is we've got to dig into the details and that that's what tells the story and unveils things that you may not even know are normalizing entries and especially when, you know, you as the, as the selling shareholder or thinking about selling your business to an ESOP. You're really in an advan advantageous position to continue to, to look at that and, and collaborate with your advisor and discover what those adjustments could be. And you, as you, as you'll see in my example, that's gonna have a particular impact on your evaluation. So you're gonna, you're gonna really care about that. They may evaluate the operating expenses or trends and really just look for, you know, changes in um each of the years and determining from those changes. One of the, one of the ways we might do that is, is do a percentage income statement. So looking at all of your accounts on a percentage basis and then looking for trends and one-time anomaly so that we could uncover those. And it's kind of like the rule here is obviously look for the bigger ones and go down. So that you're not getting caught up in, you know, trying to track a couple of pennies here or whatever. It needs to make sense from a, from a time spent um in terms of this part of the project. Now, the world of normalizing entries can be broken down into two categories, and I think it's important to understand these categories and I'd say the type A type of category is um normalizing adjustments that are um eliminating one-time gains or losses, um, unusual items that you had in your business, non-recurring um aspects of your business expenses, and then non-operating assets or non-operating assets that are related to non-recurring expenses. So When you look at these types of adjustments, um, what you're really looking to do is, is to understand that, um, these, you know, as I, as I call them like one-time adjustments are really not gonna continue in the future. And, and that's why when you ask the question of what's, what's happened that's been unusual in your business, um, that will help kind of unveil some of those. Now, the other type, it, it would be adjustments related to the owner or the officer of the company, really discretionary type of expenses that um if you had a company that, you know, I, I don't want to use the term like company that just runs better. Um, it, it's obviously companies that have less discretionary expenses can use that cash flow, um, to build a better business, but it doesn't mean that the business is more successful. It just means that that is part of the way that they run their business. So, um, sometimes discretionary expenses um are spent on things, um, and they don't really need to be spent. And so if we can look at those as potential adbacks, that's gonna be important. So those are your two categories. It's the one time. You know, hits the non-recurring and the ones that are really adjusted around dis uh discretionary type of um expense that doesn't need to exist. So we're, we're gonna go into some examples of these and just to give you kind of some highlights and then we're gonna get into um a specific example in our, in our episode here. Discretionary personal expenses, so these are expenses that management currently incurs but um really have no impact on the day to day operations of the business. They're personal expenses paid by the company on behalf of a business owner, um, that would not be necessary or on a post-transaction basis. So some of this is to think about when we have these questions is what is on an ESOP, what is your pre-transaction, you know, accounting look like? And then what is your post transaction accounting look like? So, if we're gonna have a um a selling shareholder leave the business or reduce their, their compensation after the transaction, that's gonna be, you know, part of that, um, part of this, but there might be other discretionary expenses that they're spending money on. Like entertainment that necessarily isn't necessary for the business. Um, that could include personal travel, um, it could include, um, you know, meals and, and different types of things that, uh, just get accumulated in the business. Hunting, I mentioned hunting at the beginning, or it could be other things. Um, there might be excess intercompany fees and payments to, um, other entities that necessarily, don't necessarily need to continue. Uh, the, the company might have had assets that have sold that are not going to recur in the future. The company might have had, uh, possibly a one-time event. Um, it could be a litigation issue that they settled. It could be, um, a non, you know, an an external issue completely that like a, uh, a devastating storm or um a fire or whatever, and they got recovery from that, from an insurance standpoint. It could be a settlement on um the potential life insurance could be, you know, a lot of these that are, that are again com not common sense, but in the sense they're, they're, there are things that happen in the business that just have to be uncovered and asked. So when you look at it, As I, as I kind of led into the process, it's going to be looking at the financials a lot and asking questions related to that, to that, say 5-year time period and just saying, hey, what happened here, what happened there? And I think that's what the advisor needs to be, needs to be doing. Um, when you look at executive compensation and you start thinking about the what, what the officers are paid, um, many times you're gonna want to do a, some type of study or look at fair market value compensation for owners and managers just to determine if, if that is truly fair, if you have some specific questions about it. There might be uh third party entities or related party entities that are, are related to the company like an LLC that owns the real estate. And they lease the real estate back to the company. The question is, you know, obvious, is that rent fair market value or is it below or above market value? When you're doing an ESOP transaction, the lease will get, you know, evaluated in due diligence and there will be um necessary part of the data that you're gonna, or the, the data room, you're gonna have to provide um comparables to the trustee and their adviser to determine whether or not those, those rents are justified or not. And then there would be appropriate adjustments on the, the cash flow from there. They mentioned before that there might be extraordinary um expenses that have happened and they won't happen in the future, um out of period expenses, um where they overlap into different periods and we wanna make sure we've adjusted the books and records correctly. Many times when you have year-end audits from CPA firms, that's probably not as much of an issue as when you have internal financial statements and we have overlap between different periods. Now, one of the issues that we get into in evaluation is non-operating assets, and a non-operating asset is definitely gonna affect the evaluation and, and it happens um specifically with, you know, when you get a company that has a lot of working capital, so you have this excess working capital, that's technically a non-operating asset and the value of that non-operating asset gets added back to the valuation. But there are other non-operating assets that will play a role if the company has An asset that has nothing to do on the books and records of for the company then, and sometimes there, there might be um a condo or, or some type of real estate that the business has um Kept or whatever on the books that doesn't really have anything to do with the operations. And tied to that non-operating asset, there might be outflows of cash for property taxes or insurance or other things that would be um important for them to be removed from the income statement. And so those would be adjustments that we make in the balance sheet in, in the income statement. So an example of this might be um a manufacturing company that's holding a piece of vacant land, and this would be, they don't need it for the operations, but this would be a non-operating asset. And so when we would have, we would have real estate taxes related to that vacant land, we would be looking to add back those taxes and get rid of the, the vacant land as part of our operating entity, our operating assets. Um, there might be real estate loans as well that are related to that, so we might want to add back, um, you know, the interest expense and other aspects of the non-operating liability to the balance sheet. So that gives you kind of an, a good overview of, of some, and we're gonna get into some details. So it hopefully will make more sense as we go through this. Um, one of the aspects of this though is control versus minority ownership. And the reason this is important is because as a controlling interest, that just means I control the entity as, as the single, maybe the majority owner of the business. That person or persons has the ability to affect. Um, the, the, some of the type of normalization entries that you might have. And if they're, if they're selling a minority interest to an ESOP, that means that they may or may not be, um, um, changing those discretionary expenses. Because they're in control of the entity, they don't necessarily have to. And when it comes down to this, and it's, it's debatable, but the issue is, is does the minority owner have the ability to affect, say for instance, compensate the owner's compensation that might be in excess of fair market value or fair market compensation. If they don't have the ability to affect that. From a transactional standpoint, then if you're selling a minority interest, then, then the real issue here is how can the minority valuation really include that additional cash flow that would be freed up on a controlling premium. So, so that's the issue you get into with control versus minority. And the questions that you have, not to make it too complicated, but they do have to be, they have to be thought through and I think that's the gist. From where I would come from is that, is the minority owner have the ability to change the expenses that are being made. If they don't, I think you gotta say that can't be a control, that can't be an adjustment right now. It will be eventually when the company sells controlling interest, but right now for the minority sale. Um, a lot of times when, when you have a controlling sale, then this, these kind of discussions don't really matter because the controlling interest is the ESOP controlling company is, is clearly going to make these adjustments back, um, whether they're, you know, just discretionary expenses or um adjusting correct compensation. So some control adjustments that you would have, um, and I mentioned these a little bit, but to categorize them a little bit deeper would be excess officer compensation. Um, that could be, you know, they may have, um, luxury cars in the business, they might have country club memberships and things like that, that might be part of it. They may have um something specific that they're getting paid that they wouldn't get paid in the new, in the normal course of things. Um, you might have the, I mentioned the rent payments, excess, um, or below market rent, that would be adjusted. Um, I mentioned the travel and entertainment of the shareholder. Um, so some of these are just redundant, but I wanted to kind of repeat those. Because they categorize themselves towards more of control adjustments. So with that, let's go into an example. So that we can illustrate how normalization entries work, and how they can really add up and like I said, greatly impact the business valuation. So in a company called Norms Brewery. Which is a privately held business and as you can tell from the name, they are a um a company that makes beer. And they have only in this example, one shareholder and his name is. Norm, and he works enough to justify himself, but he, every afternoon heads down to his favorite pub and has his beer and um or multiple beers, but his company has revenue of $15 million a year and they have a net operating income or net profit of $100,000 which doesn't seem like a very big margin. So when the evaluator goes through the process with Norm, because he is looking to sell his company to an ESOP, um, they determine based on the valuation that he would come in at around 500,000. And Norm is like, hey, that's not enough in order for him to retire, and he's concerned at this point because he's really thinks he's gonna have to work another 20 years, um, in order to make sure he's enough beer money, but Anyway, he um is concerned and then he, the evaluation firm kind of, you know, calms him down and says, hey, you know, Norm, we haven't actually gotten through the whole evaluation yet. We've got some questions to ask you. And so they engaged with some questions and These are, this is what comes out of the conversation. It, it turns out that Norm's Business, Norm's Brewery was sued, and they were sued because they had an accident on the, the site and it was settled, and it ended up costing them $500,000 of legal expenses. So because this was settled and the legal, the that litigation is over, then they basically are feeling good about that potentially being a normalization entry. Then it turns out that Norm also takes a $500,000 salary, and He also um. Well, for the $500,000 he doesn't work that many hours. So, um, he does plan after he sells the ESOP in a post-transaction world to work way less than he's working and has agreed to a $100,000 consulting fee a year. So that's gonna get the evaluator another $400,000 back. So now we have it's starting to add up and you can kind of see where this might be going. And further questions, it also turns out that Norm has a condo in the business in downtown Boston, and he stays there occasionally when he has had too many beers to get home. Now, the condo costs the business $200,000 a year. Now, the condo also has property taxes and insurance that cost the business $10,000 a year. And so those could potentially be added back to the income statement. More questions come and, and Norm answers them and it turns out that the business has spent $300,000 on a new software that fully integrates the entire business operation. That includes inventory management, the accounting package, as well as customer relationship data. Because they spent that much money, but there is an ongoing cost of $100,000 there's going to be a potential ad back of $200,000 because that was the difference in how much it costs to install that software and they won't need it in the future. And it also turns out after further questions that Norm's friend Cliff Clavin, who also works as a full-time mailman, has been on the salary as a beer sampler consultant, or been a consultant and has been charging the company $100,000 a year. And in the wisdom of the evaluation firm, they've determined that's probably not necessary going forward. So the first thing I'm gonna do is, as I, as I go through this example, I'm going to categorize these and, and want to say at the, at the outset that we're selling and controlling interest in the business. So that means Norm's gonna sell 100% of his stock to the ESOP. So that makes it easy, easy as I, as I discussed the issue of normalization with um controlling Primus. So everything's gonna be on the table that we talked about. So that, the first category that we talked about, the non-recurring items are gonna be um Dealing with the fact that the lawsuit was settled, that's gonna get us $500,000 on an ad back. Now, we're gonna add to that that it turns out the software that we discovered um that we don't need to pay the additional fees anymore because we've already got it implemented is another $200,000. So that's gonna get us $700,000 in ad backs. It also turns out that, you know, Norm's condo is definitely not necessary and so we're gonna be able to add back the $200,000 a year expense for that. And the property taxes and insurance is going to be another $10,000. So, so we have 700 plus 2 $900 910,000 dollars of add backs just in the first category. And the, the next category as we look at discretionary expenses when we're thinking about the salaries, is we're going to get to also add back a $400,000 for norm, his excess compensation, and also $100,000 from poor Cliff Clavin. And so that's another 500. And all in all, that's gonna get us total add-backs of 1.4. million dollars or $1,410,000. And so, when we add this back to the cash flow of $100,000 we have actually cash flow of $1.5 million or $1,510,000. And when I, when we go back to the math, we're gonna actually have an approximate new valuation of $9 million. So what was 500,000 jumps to $9 million and it seems like an extreme example. And I was purposeful in the extreme example, but I wanted to get across. That to the listener that these adjustments really need to be dealt with and they're of critical value to your planning. As you go through this process with your advisor, I'm just gonna strongly encourage you to ask the questions and, and hopefully this better, you know, better helps you to understand the categories behind how these normalization entries. Now, the, the problem that I have in this podcast is it's, there's not enough time to exhaust all the possibilities of normalizing entries. Um, but you should have from here a very good overview of, of asking the right questions and the importance of this step. Now, as I finish out this podcast, I just wanted to say, you know, making your way in the world today takes everything you got. Making the most of your out of your evaluation by norm. Alyzing your cash flow. I hope you laughed on that one. is very important and you, you need to pay attention to this, to this. You might want to listen to it one more time, but um very important information and As I finish, I just want to say, as we take our next step into this journey to an ESOP, please subscribe, rate and review the podcast and share it with a friend. Thank you so much.