As we move up the levels of value chart from the marketable minority level to the levels of financial control and strategic control, we see that it is possible that a controlling shareholder may make adjustments to expected cash flows based on the expected ability to run the existing enterprise better (financial control), or to modify or manage the enterprise differently (strategic control).
Such adjustments are control adjustments, and increase value if such adjustments would normally be negotiated between buyers and sellers.
In other words control adjustments are those that, if appropriate, increase enterprise cash flow above that of the (normalized) marketable minority level.
Normalizing and Control Adjustments Applied
Having described the general nature of normalizing adjustments and control adjustments, let us examine their proper application.
- Normalizing adjustments adjust private company earnings to a reasonably well run, public company equivalent basis. Normalizing adjustments can be divided into two types to facilitate discussion and understanding. Normalizing adjustments are not control adjustments. In the last post, we derived normalized operating profit of $1.5 million for ABC, Inc., after making normalizing adjustments for nonrecurring items and excess owner benefits. This placed normalized earnings on a public-equivalent basis (as shown in the left column in the table below).
- Control adjustments modify normalized private company earnings to reflect 1) the operational improvements anticipated by the typical financial buyer; and 2) synergies or strategies of particular buyers. Control adjustments can also be divided into two types.
Many Business Appraisers Do Not Distinguish Between These Two Different Types of Adjustments
This nomenclature for income statement adjustments is fairly new. Many appraisers do not distinguish between normalizing and control adjustments or between types of normalizing and control adjustments. This failure by some appraisers to distinguish between two significantly different types of adjustments leads to confusion on the parts of users of valuation reports and courts.
Financial Control Adjustments Defined
Financial control adjustments modify private company earnings for the economies or efficiencies available to the typical financial buyer, but are not applicable to the marketable minority basis of value.
Financial Control Adjustments In Practice
Prospective financial control buyers may consider adjustments to the income statement that can improve the normalized earnings stream. In other words, financial control adjustments are appropriate if the typical buyer could expect to manage the existing company better.
We live in an expectational world. If a prospective financial buyer reasonably believes that a particular change will improve earnings and/or growth, that buyer may be willing to share a portion of that benefit with the seller. If there are other purchasers with similar expectations, market value may be bid up shifting a significant portion of that benefit to the seller. For example, financial control adjustments might be reflected in a negotiation or in an appraisal at the controlling interest level if the indicated economies or growth prospects are generally available to multiple buyers and bidding competition transfers those benefits to the seller.
Financial Control Adjustments – An Example
Assume that ABC, Inc. reports selling costs of $700,000, or 7% of sales. Selling costs for the most efficient companies in the industry run on the order of 5.5% of sales, so there is a potential benefit of $150,000 from a reorganization or restructuring of the selling process.
Recognizing this potential, financial and/or strategic buyers may consider adjusting the income statement for such expected benefits. Such an adjustment – the potential increase in earning power by as much as $150,000 - would be a financial control adjustment.
ABC’s earnings, after appropriate normalizing adjustments, increased from $300,000 to $1,500,000, and the operating margin increased from 3.0% to 15.0%.
With the consideration of financial control adjustments, expected operating income increases by an additional $150,000 to $1,650,000, or to 16.5%.
As it turns out, ABC, Inc. is actually a very profitable company and can likely be even more profitable under control of new buyers.
Strategic Control Adjustments Defined
Strategic control adjustments modify private company earnings for the potential strategic synergies/benefits available to a particular strategic buyer. Therefore, strategic control adjustments reflect changes stemming from an expected interaction between the subject company and other assets in the strategic buyer’s portfolio.
Strategic Control Adjustments In Practice
Strategic benefits may arise from several sources, including consolidation of general and administrative expenses, lower costs of goods sold because of higher volume purchasing, benefits from horizontal or vertical integration, the ability to achieve lower financing costs, and others.
Strategic buyers do not contemplate operating the acquired business on a stand-alone basis, but rather in conjunction with other businesses currently owned (or expected to be acquired).
Strategic buyers may also seek beachheads in an industry, thinking it cheaper to “pay up” by anticipating future synergies rather than to build from scratch. Other considerations include the preemption of other competitors from obtaining a certain “space.”
Strategic Control Adjustments – An Example
With ABC, Inc., one or more strategic buyers might reasonably believe that their larger purchasing volumes could lower cost of goods sold by $200,000, and that a consolidation of general and administrative expenses could eliminate an additional $250,000 of expenses.
So the strategic buyer is looking not at the $300,000 of reported earnings for ABC, Inc., or at the $1,500,000 of reported earnings as normalized, or even at the $1,650,000 given financial control adjustments, but potentially at $2,100,000, with strategic control adjustments, as shown in the figure below.
Additional Thoughts on Normalizing Owner/Management Compensation
We see the importance of differentiating between normalizing and control adjustments.
Normalizing adjustments adjust for unusual and non-recurring items. Unless adjustments are also made to normalize owner/management compensation, the underlying value of an enterprise may be missed entirely.
The enterprise itself is not worth less because an owner takes compensation in the form of non pro-rata bonuses than if she pays herself a market wage and distributes earnings on a pro-rata basis (or reinvests to the benefit of all owners).
- To the extent that excess owner/manager compensation reduces shareholder distributions, this can impact value to individual shareholders’ interests.
- To the extent that excess owner/manager compensation (or, for example, the mere accumulation of non-operating assets) reduce future growth opportunities, the expected future value of the business may be impacted and therefore, the present value of illiquid minority interests may be reduced.
Control and Normalizing Adjustments and Statutory Fair Value
It is important to recognize that normalizing and control adjustments are the ways in which appraisers “peel back the onion” and understand underlying business (enterprise) value at given points in time.
In the context of our ongoing discussion of statutory fair value, recall the guidance of Beway (Matter of Friedman [Beway Realty Corp.], 87 NY2d 161) that suggests that minority discounts should not be taken because it would provide benefit to the controllers of a corporation in excess of that available (fair value) to minority owners.
The failure to normalize earnings for excess owner compensation, for example, would be analogous to imposing a disguised minority discount, which would be contrary to judicial and statutory guidance.
Normalizing and control adjustments influence the transparency of expected cash flows of businesses. Value is all about expected cash flow, its growth, and risk.
Shortly, we’ll begin to circle back more specifically and talk about the cash flow implications of normalizing and control adjustments in the context of the levels of value.