Why is normalized income so important when selling a business?

When you sell a business, everyone wants to know how much money does it make? Although that may seem like a very straight forward question, the answer is not that straight forward. Private business owners typically put in many personal expenses through their business, they may income split with family members, they may put a variety of other expenses through that will not be a required expense for the new owner. The definition of normalized earnings is the earnings that should be enjoyed by the new business owner after he/she acquires the business?

The items which are considered normalized earnings are often disputed by the buyer and seller because the value of the business is dependent upon the definition of profits/normalized earnings of the business. What is an extra expense to one person may be normal to another. Clearly paying a salary to a family member who is not working in the business is not a normal expense and would be added back.

I have seen people say that I went on a business trip and say it was personal. They claim that they saw one client in another city then continued on a holiday – is that personal or business? I knew of another who was a member of a buying consortium and the members would meet once a year in their respective countries. They discussed business for an hour or two, was the trip business or personal?

The owner of the business needs to be paid a salary if he/she worked in the business. What would you have to pay a person to do that owners job? Any amount paid to the owner in excess of this amount would be considered a payment as a shareholder and would be added back to net income to create normalized income but if he/she was not paid anything, there should be a salary imputed and deducted in the calculation of normalized earnings. How do you determine what is a fair salary for that person to make? Is it $50,000, is it $100,000 is it $150,000 – all may be reasonable depending on the size and nature of business. If the owner is taking out $1 million, you do not add back $1 million and consider it part of the profits, you take the $1 million and subtract out an amount which would be a salary paid to a third party to run the business, only the excess would be added back to normalized income.

If an investor is paying a multiple of normalized earnings, establishing normalized earnings is very important. If the business is receiving a lot of business due to infrastructure spending, should this be added back to normalized earnings because it is a temporary increase in earnings? In Ontario and British Columbia, the government is implementing HST. if a business paid a lot of PST in the past, should add that to profits now because that tax would not longer be a cost? In the past, many investors may not have spent a lot of time analyzing normalized earnings. As the world is changing and businesses are being impacted by outside items, infrastructure spending, sudden changes in exchange rates, new taxes, these all impact the value of a business and I am not sure if buyers of businesses are paying enough attention to calculating this figure before putting a value on the business they want to buy.