Understanding Financial Normalization in M&A

Financial normalization adjusts a company’s financials to reflect its true earning potential. By removing non-recurring, personal, or unusual expenses, it ensures buyers, sellers, and lenders see accurate, sustainable cash flows. This process is vital in M&A, as valuations often rely on EBITDA multiples - every $1 adjustment can significantly increase the purchase price. For example, a $50,000 adjustment in a deal with a 5.0× EBITDA multiple can add $250,000 to the valuation.

Key adjustments include:

• Discretionary Expenses: Removing personal travel or non-business costs.
• Executive Compensation: Adjusting overpaid owner salaries to market rates.
• One-Time Events: Excluding legal settlements or extraordinary revenue spikes.
• Related-Party Transactions: Correcting for below-market rents or non-arm’s-length deals.

Buyers focus on verifying these adjustments, while sellers aim to maximize them. Proper normalization reduces risks during due diligence, builds trust, and ensures fair valuations. Tools like Clearly Acquired streamline this process, helping businesses prepare accurate financials for smoother transactions.

10 Adjustments to EBITDA

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Core Concepts and Frameworks

Normalized EBITDA, SDE, and Net Working Capital

Normalized EBITDA takes the standard EBITDA figure and adjusts it by removing non-operating, discretionary, and one-off expenses. This adjustment provides a clearer picture of a company's true earning potential. For example, if a business reports $500,000 in EBITDA but includes $75,000 for personal travel and $25,000 for a one-time settlement, the normalized EBITDA would increase to $600,000.

Seller's Discretionary Earnings (SDE) goes a step further, adding back the owner's total compensation and benefits. This is particularly relevant for smaller, owner-operated businesses. It highlights the full financial benefit available to a potential buyer who plans to actively manage the business. For instance, if the normalized EBITDA is $600,000 and the owner receives a $150,000 salary, the SDE would total $750,000.

Net Working Capital (NWC) refers to the cash required for daily operations, typically calculated as current assets minus current liabilities. In mergers and acquisitions (M&A), buyers and sellers negotiate a target or "peg" level of working capital to be delivered at closing. Changes in NWC can directly impact the cash available to the business after the transaction and play a key role in discounted cash flow valuations as part of free cash flow calculations.

Types of Normalization Adjustments

Normalization adjustments address inconsistencies or distortions in reported financials, ensuring a clearer representation of earnings:

• Discretionary and Personal Expenses: These include non-business costs like the owner's personal travel, club memberships, or non-business meals. These expenses are typically excluded under new ownership.
• Executive Compensation Adjustments: If the current owner or family members are paid above-market salaries, the excess is added back. For example, if the owner earns $200,000 annually but a replacement manager would cost $120,000, the $80,000 difference is added back. Similarly, salaries for inactive family members with minimal involvement are adjusted.
• Related-Party Transactions: Adjustments are made for transactions that are not at market rates. For instance, if a business pays $3,000 in monthly rent for owner-owned property while the fair market rate is $5,000, the $2,000 monthly shortfall ($24,000 annually) is subtracted from normalized earnings.
• Non-Recurring Items: One-time events like legal settlements, restructuring costs, or gains from asset sales are excluded to reflect typical earnings. For example, a roofing company that earned an extra $200,000 in a single year due to storm damage repairs would adjust this spike to reflect normal operations.
• Accounting Policy Differences: These adjustments correct inconsistencies in accounting practices, such as failing to accrue bonuses monthly or recording expenses in the wrong period.

Adjustment Category	Examples	Impact on Normalized Earnings
Discretionary/Personal	Owner's personal travel, non-business meals	Add back (increases earnings)
Executive Compensation	Above-market owner salary, inactive payroll	Add back excess (increases earnings)
Related Party	Below-market rent	Subtract difference (decreases earnings)
Non-Recurring	One-time legal settlements, restructuring	Add back (increases earnings)
Accounting Policy	Out-of-period expenses, inconsistent accruals	Adjust to reflect correct period

These adjustments are critical for both sellers and buyers, shaping how earnings are presented and validated.

Seller vs. Buyer Perspectives

Sellers and buyers approach normalization with different objectives. Sellers aim to maximize the benefit stream by identifying all legitimate add-backs, as many deals are priced using an EBITDA multiple. For example, in a transaction with a 5.0× EBITDA multiple, a $100,000 adjustment could add $500,000 to the purchase price.

Buyers, on the other hand, focus on verifying and sustaining those earnings. They rely on financial due diligence and Quality of Earnings reports to ensure adjustments are reasonable and earnings are sustainable. Buyers may challenge aggressive add-backs, such as questioning whether an $80,000 owner salary should be fully normalized when a replacement manager would cost $75,000, or disputing whether a one-time revenue spike represents ongoing income.

"It is in the best interest of both sides of a transaction to accurately represent and clearly understand the benefit stream(s) driving the pricing of the transaction."

• Daniel Glomski, CPA, ABV, CVA, MST, Principal, SVA Certified Public Accountants

Proper normalization ensures sellers receive fair value while protecting buyers from unrealistic earnings expectations.

How to Normalize Financial Statements

Preparing Your Financial Package

Start by gathering three years of annual financial statements, including the profit and loss statement, balance sheet, and cash flow statement. Alongside these, collect supporting documents like payroll records, lease agreements, and detailed ledgers. To ensure all potential adjustments are captured, create a schedule listing personal and discretionary expenses - think vehicle costs, non-business travel, club memberships, or family cell phone plans. These adjustments can significantly impact the valuation of your business. For example, in a deal with a 5.0× multiple, identifying a $20,000 adjustment could add $100,000 to the purchase price.

Identifying and Adjusting Non-Recurring and Owner-Specific Items

Once you’ve assembled your financial package, the next step is to focus on adjustments that reflect the business’s true operating performance.

• Owner’s Salary: Compare the owner’s salary to market rates. If the owner is overcompensated, the excess can be added back. For instance, if the owner earns $180,000 but the market rate is $110,000, you can adjust by adding back $70,000.
• Family Payroll: Check payroll records for family members who aren’t actively involved in the business. Their salaries should be fully added back.
• Leased Properties: For properties leased from the owner, adjust for any difference between the actual rent and market rates. For example, if the owner charges $2,500 per month but the market rate is $4,000, you’ll need to deduct $1,500 monthly.
• Non-Arm’s-Length Arrangements: Apply similar adjustments for equipment leases, consulting fees, or any other arrangements that don’t reflect market terms.
• One-Time Expenses: Adjust for non-recurring events like legal settlements or relocation costs. For example, a $50,000 legal settlement or a $30,000 moving expense should be excluded as they don’t represent regular operations.

Finally, ensure consistency in accounting practices between interim and year-end statements. Interim reports might miss accruals like bonuses, insurance adjustments, or depreciation catch-ups. For instance, if a $40,000 bonus appears in December but wasn’t accrued monthly, interim figures could overstate profitability by around $3,300 per month. Consistent accounting is key to accurate normalization.

Creating Supporting Schedules and Documentation

To streamline due diligence and valuation discussions, create a detailed normalization schedule. This schedule should include:

• Each adjustment category
• The specific line item affected
• The dollar amount adjusted
• A brief explanation for each adjustment

For executive compensation adjustments, include market rate comparisons using data from salary surveys or similar job postings. For related party transactions, attach relevant documentation, such as lease agreements and market rate appraisals or comparable listings.

Additionally, retain supporting documents like invoices, settlement agreements, or correspondence about policy changes. These materials validate your adjustments and can help speed up the due diligence process.

If you’re working with advisors or brokers, platforms like Clearly Acquired can assist with financial normalization and positioning. They specialize in identifying legitimate add-backs and preparing documentation that can withstand buyer scrutiny, ultimately influencing both the speed of the transaction and the final purchase price.

These detailed schedules and supporting documents lay the groundwork for valuation discussions and help optimize the deal structure as negotiations progress.

Impact on Valuation, Deal Structure, and Financing

How Normalized Earnings Affect Enterprise Value

Once financials are adjusted to reflect true operational performance, the next step is understanding how these changes influence enterprise value and financing structures. Normalized earnings, particularly EBITDA, play a pivotal role in determining a business's valuation in most M&A transactions. Buyers typically apply a market-based multiple to the normalized EBITDA figure, meaning any adjustments made through normalization can significantly amplify the purchase price. As Daniel Glomski, Principal at SVA Certified Public Accountants, puts it:

"Every dollar that results from a normalization adjustment to EBITDA is multiplied by [the deal multiple], resulting in more money landing in the seller's pocket".

For example, identifying $50,000 in legitimate add-backs - such as personal expenses, family payroll for non-active members, or one-off legal fees - can have a dramatic effect. If the deal carries a 6.0× EBITDA multiple, that $50,000 adjustment adds $300,000 to the enterprise value. While the deal multiple depends on industry benchmarks and market conditions, normalized earnings provide the foundation for this valuation. These enhanced earnings figures don’t just affect the purchase price - they also play a critical role in shaping the deal structure and influencing lender confidence.

Normalization in Debt Financing and Lender Underwriting

Normalized earnings are also a key focus for lenders during the underwriting process. Lenders rely on these adjusted financials to determine whether the business can comfortably manage debt payments post-transaction. This is especially important in Leveraged Buyouts (LBOs), where debt financing often accounts for 70% to 90% of the purchase price. During underwriting, lenders scrutinize discretionary expenses, ensure executive compensation aligns with market standards, and verify that related-party transactions - such as below-market rent - are adjusted to reflect actual economic costs.

Consistency in accounting practices is another critical factor. If interim financials show strong performance but fail to account for accruals like year-end bonuses or insurance adjustments, lenders will flag these during their quality of earnings review. For SBA 7(a) loans and other financing options, thorough documentation is non-negotiable. Lenders require clear, well-documented evidence to avoid delays or complications during the approval process.

Reducing Risk Through Proper Normalization

Proper normalization helps eliminate surprises during due diligence, bolstering confidence for both buyers and lenders. When financial statements accurately reflect the business's true earning potential, the risk of deal disruptions - such as buyers renegotiating terms due to unexpected issues - is significantly reduced.

For sellers navigating this process, tools like Clearly Acquired can be invaluable. Their AI-driven financial analysis and normalization support identify legitimate add-backs and prepare detailed documentation. This not only helps maximize the final purchase price but also streamlines the transaction process, cutting down on back-and-forth during due diligence.

Conclusion

Financial normalization plays a crucial role in achieving accurate valuations and successful transactions within the SMB and lower-middle-market sectors. By removing discretionary and one-time expenses, businesses can present a clear picture of their true, ongoing earnings. This transparency benefits all parties involved: sellers can command a higher purchase price, buyers avoid overpaying for unsustainable profits, and lenders gain confidence in the business's ability to meet debt obligations.

Identifying add-backs, such as personal expenses or one-off costs, can significantly boost enterprise value through the deal multiple. For instance, in a transaction with a 5.0× EBITDA multiple, every dollar of normalized earnings adds an extra $5.00 to the purchase price. This compounding effect underscores why normalization is a critical step in the M&A process.

Beyond valuation, normalization reduces risks during due diligence. When financial statements reflect accurate, forward-looking earnings, negotiations become smoother, and lenders are more likely to approve financing. With fewer surprises, transactions can move forward with greater confidence and certainty.

For business owners planning an exit or buyers using a business acquisition checklist to assess potential acquisitions, thorough financial normalization is essential. Tools like Clearly Acquired simplify this process through AI-powered financial analysis - helping to pinpoint add-backs, organize documentation, and present a strong case to buyers and lenders. In the world of Main Street M&A, proper normalization is the key to achieving better outcomes for everyone involved.

FAQs

What are the common pitfalls to avoid during financial normalization in M&A?

Financial normalization plays a key role in showcasing a business’s real earning potential, but even small missteps can lead to distorted valuations. Here are some common mistakes to watch for:

• Overlooking one-time or non-recurring items: Extraordinary expenses or sudden revenue spikes often get left in calculations, throwing off EBITDA accuracy.
• Misclassifying owner-related expenses: Items like personal expenses, discretionary salaries, or perks unrelated to daily operations can understate actual profitability if treated as standard costs.
• Ignoring differences in accounting policies: Variations in practices like revenue recognition, depreciation methods, or inventory valuation can create misleading financials if not properly adjusted.
• Missing related-party transactions: Deals or transactions with affiliates can skew cash flow and margins unless they’re normalized.
• Failing to adjust working capital or excess cash: Abnormal levels of inventory, prepaid expenses, or surplus cash can distort earnings and even impact deal negotiations.

To tackle these challenges, Clearly Acquired leverages AI-driven tools to spot and adjust for these issues. This ensures both buyers and sellers have access to accurate, normalized financials, enabling smarter decision-making.

What role does financial normalization play in M&A negotiations?

Financial normalization plays a key role in creating a reliable and consistent earnings baseline, which is essential for smooth negotiations between buyers and sellers. By adjusting for one-time, discretionary, or out-of-the-ordinary expenses, this process ensures the financials accurately represent the business's true operational performance.

By doing so, it reduces potential disputes over earnings quality, allowing both parties to concentrate on reaching a fair and agreed-upon valuation. This not only simplifies negotiations but also builds trust in the deal's groundwork.

Why do lenders need to review normalized financials during M&A transactions?

Lenders analyze normalized financials to get a clearer picture of a business's actual earning potential and steady cash flow. By stripping out irregular expenses, one-off revenues, and accounting discrepancies, these financials highlight the company’s ongoing financial health.

This approach allows lenders to better evaluate credit risk and design financing solutions that match the company’s long-term profitability and ability to repay.