The Importance of Normalization Adjustments in Determining a Marital Asset Distribution

In a divorce proceeding, marital property may contain ownership interests in private or closely held companies that are either family-operated or operated with the divorcing party’s involvement. In these proceedings, an analyst must consider adjustments to a company’s financial results as a significant part of the valuation engagement.

Adjustments allow an analyst to accurately capture the fair market value of a business interest, in turn arriving at the value due to each party’s respective interest in the business. Normalization adjustments aim to present information comparable to that of other companies and provide a foundation for developing future expectations about a subject company.¹ Similarly, the goal of controlling adjustments is to arrive at a company’s value based on the assumption that the ownership interest being valued has control over aspects of the company and could use it to impact changes within the company.²

The International Valuation Glossary – Business Valuation defines fair market value as “a Standard of Value considered to represent the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, each acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of relevant facts.” With this definition of fair market value in mind, determining what should and should not be included in a company’s normalized financial statements can be one of the most important steps in the valuation of a closely held business.

When arriving at the normalized level of a company’s cash flows, valuation experts often find a rift between one another’s adjusted results, which results from differing opinions on normalization adjustments.

While every company is unique, there are general guidelines that all valuation professionals must keep in mind when deciding whether to make normalization adjustments. We can categorize normalization adjustments into the following categories:

1. general
2. nonrecurring; and
3. nonoperating.

In addition, controlling adjustments can be placed in a separate category, as adjustments for control require specific consideration of the level of control of ownership interest and what can and cannot be affected by the owner of said interest.

It is necessary to note that there is often significant overlap in normalizing categories. An item may be considered both a nonoperating and a control adjustment, but the treatment of that adjustment could differ depending on the circumstances.

1. General Normalization Adjustments

General normalization adjustments are largely accounting considerations that seek to eliminate or adjust items to align the financials with industry standards or better represent the company’s operating earnings.

Examples of general normalizing adjustments include, but are not limited to:

• Removal of unusual gains or losses on the sale of assets
• Shifting the timing of recognition of revenues and expenses
• Standardizing depreciation methods and schedules

Additionally, rent expense often needs to be adjusted to market levels. While this may also be considered a control adjustment if rent is paid to related parties, a normalizing adjustment may be necessary even if rent is not between related parties. For example, a rental adjustment may be needed when a lease is up for renewal, rent is expected to change in the future, or remote work is the new standard and office space can be downsized. Rent expense can be examined by looking at market rates of comparable properties based on factors such as square footage, location, and use/type of property (industrial, commercial, etc.).

It should be noted that market rent is not always discretionary on the part of the analyst, such as when it can be tied directly to an appraisal or other source.

2. Nonrecurring Adjustments

Nonrecurring items are revenue e or expenses that happened in the past but are not expected or likely to occur again.

In recent years, income related to COVID-19 relief programs (including the Paycheck Protection Program, or PPP) has commonly been subject to adjustment. If a PPP loan has already been forgiven, the forgiveness proceeds from the loan may also be subject to adjustment.

However, if the proceeds from a PPP loan can be considered a replacement for revenue, such as if they were used to cover the operating expenses of the company in the impacted period(s), therefore making it possible to leave in the PPP income, assuming the business needed to generate the cash flows that are being valued. On the other hand, given the uncertain nature of pandemics and government relief programs, PPP income is unlikely to occur again. Assuming the proceeds from the PPP loan were held as cash, distributed to owners, or served some other purpose not directly contributing to the company’s operations, the PPP income can be removed as nonrecurring.

Other items that may be adjusted out as nonrecurring include, but are not limited to:

• Litigation and professional services expenses
• Gains and losses from the sale of assets and investments

Note that a nonrecurring item may occur in multiple years but still be considered nonrecurring when looking at the likelihood it will occur again in the foreseeable future.

3. Nonoperating Adjustments

Nonoperating items include components of a company’s finances that are not part of its core business operations. Nonoperating assets may consist of investment accounts depending on the nature of the business being valued. In fact, income from investments is the most commonly found nonoperating item on financial statements.³

When valuing a closely held business, aspects of the company’s operations and finances may not align with the characteristics of similar companies. Therefore, focusing on the services or expenses needed for the subject company to operate is essential. An indication of expenses considered extraneous and nonessential is if the item or service could be removed without impacting the company’s future operations. Examples include, but are not limited to:

• Investment portfolios and related income and expenses
• Life insurance premiums attributable to an owner/shareholder
• Gains and losses from the sale of assets and investments
• Charitable contributions, if not for marketing or some other component of the business

Controlling Adjustments

A sole owner of 100% of the equity in a company, or with voting control of the equity, has control over that entity. Essentially, possessing voting rights in a company, having oversight of day-to-day operations, and other specific rights of an ownership interest may give that owner greater control.⁴

Control adjustments can be made when a controlling owner has the power to make such a change. These adjustments can include but are not limited to:⁵

• Modifying the salary of a family member employed at non-market rates to market rates
• Adjusting rent to a related party at non-market rates to market rates
• Removing discretionary expenses (personal credit cards, vehicles)
• Optimizing capital structure, for example, by assuming greater debt utilization

The most common control adjustment made in valuations is for reasonable compensation. In a closely held business, owners are often involved in the management of their company. In these cases, a valuation expert will typically rely on market data to determine what an executive in a similar role in a similar company would be paid. In considering reasonable compensation, an analyst may consider key data points like the company’s location and revenue level, the role of the owner (CEO, vice president, etc.), the salary of other unrelated employees, and the industry in which the company operates.

Discussions with management are a further resource, beyond reported financial statements, that can help an analyst determine what is and is not essential to the business’s operations and, therefore, what can be normalized and what should be left in.

In arriving at a conclusion of value for your closely held business, it is crucial to retain a valuation professional who understands how and when normalization adjustments should be applied to a closely held business. The ability to support and defend such adjustments is vital to any conclusion of value, as they may result in significantly different value conclusions between experts and, therefore, significant implications to the distribution of the marital estate.

Sources

1. Shannon Pratt and ASA Educational Foundation, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 6th Edition, © 2022 McGraw Hill, Page 109.
2. Ibid, Pages 110-111.
3. Ibid.
4. Ibid, Page 386.
5. Ibid, page 125.