In the last two posts (here and here), we introduced the concept of normalizing adjustments to the income statements of businesses as an essential element in the development of valuation indications at the marketable minority level of value (or as-if-freely-traded). While some appraisers still disagree regarding the applicability of Type 2 Normalizing Adjustments, we find the arguments supporting their use compelling.
Consider the following illustrative example:
In the figure above, ABC, Inc. is a company reporting sales of $10 million and operating profit of $300,000. Assume that we are appraising ABC and are now considering normalizing adjustments. There is one Type 1, or unusual, non-recurring, normalizing adjustment to be made in this particular appraisal. There are also several Type 2 normalizing adjustments that relate to the owner and the controlling shareholder of the business.
Type 1 Normalizing Adjustment (Non-Recurring Items)
- The company settled a lawsuit regarding damages when one of its vehicles was in an accident. The settlement, inclusive of attorneys’ fees, was $200,000 in the most recent year. Expenses associated with the lawsuit are eliminated from operating expenses.
Type 2 Normalizing Adjustments (Agency Costs and Other Discretionary Expenses)
- Our examination of selling expenses reveals that Cousin Joe is on the payroll at $100,000 per year and he is not doing anything for the good of the business. An adjustment is clearly called for regarding Cousin Joe. His compensation must be eliminated in order to see the “as-if-freely-traded” income stream.
- In the Administrative Department, Cousin Al comes to work every day, but it is clear that the department is being run by someone else and that Cousin Al is not productive. We adjust by removing his $100,000 salary.
- Big Daddy takes a substantial salary out of the business. Based on a salary survey, earnings should be adjusted by $600,000 for his excess compensation to lower the expense to a normal, market level of compensation.
- Finally the business owns a chalet for Big Daddy’s vacation needs, which costs the company about $200,000 a year. Expenses associated with Big Daddy’s vacation home are adjusted accordingly.
Summing the Type 1 and Type 2 adjustments, adjustments to operating expenses of $1.2 million have been identified. These adjustments raise the adjusted operating profit to the level expected were this company publicly traded (even though it likely never will be). The normalized operating margin is 15%.
Before proceeding to examine control adjustments, we should carry the discussion of normalizing adjustments a step further in order to address any lingering concerns. Some appraisers remain convinced that Type 2 Normalizing Adjustments are really control adjustments and that they should not be made when valuing minority interests.
Why, they ask, should we not value the minority interest directly and forego making Type 2 Normalizing Adjustments? Consider that if we do not make these adjustments:
- The resulting earnings stream is not comparable to those of public companies (or “as if freely traded”).
- A discount rate based on guideline company analysis would not be appropriate and the resulting value indication would not be at the marketable minority level.
- Marketability discounts referencing restricted stock and pre-IPO transactions involving public companies would be inappropriate if relevant Type 2 Normalizing Adjustments are not made. The various restricted stock and pre-IPO studies are based on marketable minority values and the resulting, non-normalized base would not be at the marketable minority level.
- There is an implicit assumption that the shareholder will never realize his or her pro rata share of the value of the enterprise. In the alternative, there is no basis to estimate what that future terminal value might be. There would be no basis, for example, to estimate the expected growth in value of the enterprise over any relevant expected holding period, since the base marketable minority value is not specified.
Absent making appropriate Type 2 Normalizing Adjustments, an appraiser cannot assure users that his or her conclusion is at the nonmarketable minority level of value, which is typically the objective of minority interest appraisals.
The bottom line is that failure to make Type 2 Normalizing Adjustments when valuing nonmarketable minority interests provides neither the appropriate theoretical nor practical bases for valuation conclusions.
Normalizing Adjustments and Statutory Fair Value
This series of posts involving an integrated theory of business valuation is being applied to statutory fair value determinations, not determinations of fair market value at the nonmarketable minority level of value. So why spend time on them? Let’s begin to address the question with a few assumptions:
- For simplicity, assume that ABC, Inc. has no debt and that the appropriate valuation multiple to determine its equity value is 5x.
- Assume further that ABC, Inc. is engaging in a transaction, the effect of which is to “squeeze-out” a 10% owner who is not related to Big Daddy. The shareholder appropriately perfected his right to dissent in accordance with the laws of the state and has dissented and is asking for the fair value of his shares.
ABC, Inc. hired an appraiser who made no normalizing adjustments. This appraiser determined the fair value of the company to be $1.5 million (5 x $300 thousand of operating profit), and the 10% owner’s interest at $150 thousand.
The shareholder hired another appraiser (who has read and studied Business Valuation: An Integrated Theory, Second Edition). This appraiser made the normalizing adjustments in the table above and capitalized adjusted operating profit of $1.5 million. Her conclusion of fair value was $7.5 million (5 x $1.5 million), and her conclusion of the fair value of the 10% interest was, accordingly, $750 thousand.
The matter is now at trial for an appropriate determination of fair value. In this jurisdiction, it is clear that no minority interest or marketability discounts are applicable. So, what is the fair value of the 10% interest in ABC, Inc.: $150 thousand, $750 thousand, or something in between?
You be the judge.
Having put you in the position of judge for our illustration, how would you begin to resolve the problem and articulate a clear valuation rationale if you lacked the vocabulary and understanding that we are developing in this series on statutory fair value? It would be difficult, indeed.
It should be clear that absent the understanding and vocabulary presented above and in the previous posts, anything you said about your conclusion would likely lack clarity from a valuation perspective. Again, let me say that I am not questioning the equitable decisions that real judges have to make. But I do hope we are beginning to create an ability to articulate conclusions in clear and consistent valuation terms.
In a coming post, we’ll address what we call control adjustments, which are distinctly different from normalizing adjustments. Then, after wrapping up our discussion of these conceptual valuation adjustments, we will turn back to the evolving discussion regarding levels of value with a sharper ability to talk about what each of the levels of value mean.