A clear description of the necessity of normalization adjustments when deriving fair market value

The idea that fair market value and investment value are most often different numbers turns out to stump may owners and interested parties--it's not particularly complicated, but hard to explain to non-appraisers.  BVR commends a recent effort in this regard by Larry Epstein and Rob Carter in the Hertzbach & Co blog.  Perhaps this clear language can help you explain this concept to your clients and prospects?

For tax purposes, the “Fair Market Value” standard is used because the IRS needs to know what the business would be worth on the open market, not to the current owner. “Investment Value” on the other hand, is the value of the business to the current owner. Normalizing adjustments are the adjustments made to the earnings stream to convert the value of a company to “Fair Market Value.”

Most people have difficulty with this concept. Adjustments are made to revenues and expenses to ascertain the earnings stream if a non-owner officer was running the company. In other words, we need to adjust the company’s financial statements to show income and expenses at amounts similar to industry averages, while leaving other company specifics the same. For example, adjustments are commonly made to owner/officer compensation for those who are over/under paid. Rent expense is typically adjusted for a company that doesn’t pay market rent because it rents from a related party. Another common adjustment is for extraordinary transactions (income and expense items that aren’t part of normal business operations) such as gain/losses from a lawsuit or the sale of a business asset. The resulting financial information (after adjustments) must demonstrate the profitability of a company without any related party, discretionary, or one time items influencing the bottom line profits.

Owners are generally concerned that making adjustments will result in a different value than what they believe is the value of their business. Owners need to understand the current/actual level of earnings translates to a value to the current owner, not the value to an outside investor. These adjustments reflect the value of the business to an outside buyer who is looking for what earnings/cash flow could be produced with a normalized level of revenues and expenses.