A company's sustainable earning capacity is the measure of its price. However, it is rare that this sustainable earning capacity can be read directly from the financial statements; after all, a company is more than just its historical figures.
Therefore, an important task of M&A advisers is to work with the client to normalize the income statement in a realistic and well-supported manner. The goal is to give a buyer insight into the company's sustainable earning power (in practice often resulting in a higher EBITDA than is directly apparent from the financial statements), since a buyer is buying what can be earned in the future.
However, normalizations can also be the starting point for divergent expectations. When these are insufficiently realistic or substantiated, a difference in value perception arises between buyer and seller. It is therefore very important to present a clear and well-founded story-line to potential buyers at the front end of the process.
In this contribution, we interpret the difference between normalization and the (unwanted) attempt to sell "castles in the air. In addition, we consider the associated risks.
A real-life case study
The DGA of a wholesaler reported an EBITDA of €3.0 million, which was normalized to €3.4 million. The DGA billed an annual management fee of €500,000. Given his limited operational involvement and taking into account a realistic, market-based budget for a replacement to be recruited by the buyer after the transition phase, this level needed to be normalized to approximately €120,000 per year (a normalization of €380,000).
On the basis of a clear and well-substantiated argumentation at the front end (as well as a total cost figure that matched the growth ambitions), the buyer accepted this normalization even after completion of the due diligence process. For the seller, based on an indicative EBITDA multiple, this resulted in an increase in de ondernemingswaarde of approximately € 2.0 million.
What buyers typically go along with
Buyers are generally willing to accept normalizations if they:
- Demonstrably one-time and/or incidental (e.g., one-time legal proceedings or moving expenses), well documented with invoices and explanations;
- Costs of excess staff, for example, that are not part of structural earning capacity;
- Present a realistic starting point of earning capacity based on concrete assumptions;
- Current trading is in line with the normalized historical level and the forecast presented.
What is important here is that normalizations logically align with how the business will continue after acquisition. For example, all costs that a buyer would also have to incur cannot be normalized.
Where buyers are critical or dismissive
Normalizations are often rejected when they:
- Structural turn out (e.g., annual "incidental" costs);
- Associated with growth ambitions (such as marketing or IT costs); this is of course closely linked to the EBITDA reference underlying de ondernemingswaarde;
- Insufficiently substantiated or based on unrealistic assumptions;
- Masking risks such as underutilization, dependence on the entrepreneur or overdue investments.
Buyers should primarily look ahead: what result is sustainably achievable under new ownership? Anything that clouds that question potentially leads to discussion.
In conclusion
It is tempting to present a company's results more favorably through normalizations. However, when the line of reasonableness is crossed, the risk of loss of credibility arises.
In practice, this often materializes late in the process, with potentially large consequences for both price and transaction certainty. It is therefore essential that sellers prepare the process carefully, working closely with a trusted team consisting of the DGA, CFO, accountant and M&A adviser.
