Deriving Normalized EBITDA for Your Business
We recently wrote an article about the dangers of failing to properly document business meal and other entertainment expenses. The piece raised quite a few concerns among business owners.
The question we most often heard usually went something like this, “Wait, I thought personal expenses like meals, travel, and entertainment could be normalized…what gives?” Answers to questions such as these, unfortunately, are never straightforward and true standards for deriving normalized EBITDA calculations don’t exist.
First, a quick refresher on EBITDA: EBITDA is a basic and widely accepted normalizing adjustment for businesses that tends to serve as a proxy for cash flow when deriving a value for the business. This measure adds expenses from the income statement like interest, corporate income taxes, and depreciation and amortization back into the value of net income to derive the firm’s cash flow.
Normalizing EBITDA before a transaction can help sellers present their business in the best light possible. However, we typically advise clients to be cautious with the level of “owner’s perks,” and corresponding normalizing adjustments, they charge to the business. Below are four of the most common adjustment categories for deriving normalized EBITDA, as well as a few words of caution where appropriate.
Non-Recurring Expenses – These are expenses (or benefits) incurred by a business that wouldn’t normally affect the business’ profitability. Adjustments to this category might include (but certainly aren’t limited to) insurance payouts, moving expenses, and losses from discontinuing operations. However, other typical non-recurring expenses like lawsuits may be questioned by a potential acquirer if the business is in an industry known for frivolous lawsuits. In cases such as these, an acquirer may deem lawsuits a normal, and recurring, business expense that needs to be accounted for in the financial statements and should not be normalized.
Personal Expenses – A broad category to say the least. Expenses like travel, meals, entertainment, personal insurance policies (e.g., key man), and discretionary bonuses tend to get lumped into this section. Although all of these expenses can be normalized, that doesn’t mean they should be. A good rule of thumb is that expenses not related to business activities shouldn’t be charged to the business.Here are a few examples:
Travel expenses: Recognizing that some may bill travel expenses not associated with the business activities through the business, owners can typically normalize these expenses.
Auto leases: These are a typical and acceptable normalizing adjustment, since some executives receive compensation or reimbursement for automobiles. The idea here is that an executive shouldn’t drive a car that would make them embarrassed to meet a client)
Meals: In most instances, meals should not be eligible for normalization. However, exceptions do apply. For example, meal expenses related to selling the business, which are non-recurring in nature and are not related to normal business operations, but are related to the ongoing nature of the business can be normalized.
Entertainment: Entertainment can be vague, which makes it a popular area for owner perks like sport or event tickets. Like other categories, entertainment should be related to business activities, but when exceptions do take place, they can be normalized.
Personal insurance policies, cell phones, and other related perks: These are generally acceptable since they are usually related to the business owner’s involvement in the business, and will not be present following its sale.
Excess Family Member Salaries – Similar to personal expenses, some owners provide family members with compensation in excess of what they would pay someone else to do the same job. Considering expenses like these would go away following a sale – presumably the acquirer would only pay fair market wages – excess family member salaries can be normalized.
Charitable Contributions – Charitable contributions may be good for your karma and can be normalized in most instances. However, if, for example, a business works with healthcare operations like hospitals, then normalizing charitable contributions to an existing or prospective client’s golf tournament may be considered a sales and marketing expense. Alternatively, charitable contributions not related to the ongoing nature of the business should be normalized.
We hope this brief explanation on normalizing adjustments provides some clarity on what is (and is not) generally accepted as reasonable expense adjustments. Also keep in mind that from an ethical and transactional point of view, improperly charging expenses to the business may save some money now, but it could cost you more in the long run during a sale if an acquirer doesn’t like what they see. We recommend reaching out to your personal accountant or M&A advisor to address any lingering questions or concerns.