The Contingent Consideration That Never Hits the P&L
You are valuing 100% of a specialty coatings manufacturer for a buy-sell dispute as of December 31, 2023. Management provides three years of tax-basis financials. Revenue grew from $18.2M to $21.4M to $23.1M. EBITDA margins were 11.2%, 12.9%, and 13.4%. Two anomalies surface: (1) In 2023 the company recorded a $1.1M "consulting expense" paid to a company owned by the founder's son; the son performs no documented services and no invoices exist. (2) In 2021 the company sold a product line and recorded a $2.4M gain, which management insists is "non-recurring" but which the owner wants excluded from normalized earnings AND excluded from the balance sheet as an asset. The owner also takes $650K in salary plus a $120K vehicle and country-club allowance, while a replacement GM would cost $410K all-in. Working capital is $2.9M versus an industry norm of 14% of revenue. The owner argues normalized EBITDA is "at least $4.2M."
1. Compute a defensible normalized EBITDA for 2023 and identify each adjustment with its rationale.
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Starting point (reported 2023 EBITDA): $23.1M × 13.4% = $3.10M.
Adjustments:
- +$1.1M add back the related-party "consulting" payment. It is a non-arm's-length transfer with no service and no documentation - economically a distribution. Add-back is standard, but flag it as a related-party item requiring disclosure.
- $0 for the 2021 gain. It is a prior-year item and already outside 2023 EBITDA; no adjustment is needed to 2023. The owner's request to also strip it from the balance sheet is wrong - the proceeds are real cash. What matters is whether the proceeds were reinvested (check capex) or distributed. Do not double-count.
- Owner compensation: excess = ($650K + $120K) − $410K = +$360K add back.
- Working capital: $2.9M vs. 14% × $23.1M = $3.23M. The company is under-invested in working capital, which inflates EBITDA relative to a normalized operator. This is not an EBITDA add-back - it is a working-capital adjustment in the capitalization/DFC bridge. Note it, but do not add it to EBITDA.
Normalized EBITDA ≈ $3.10M + $1.1M + $0.36M = $4.56M.
The owner's $4.2M is actually low relative to this math - but only because the related-party add-back is aggressive. A conservative reviewer might haircut the $1.1M to reflect that some of that spend may have supported the business. Present a range ($3.5M–$4.6M) and disclose the assumption.
2. The owner insists the $2.4M gain is non-recurring and should be removed from both earnings and equity. How do you respond, and what does this reveal about normalization discipline?
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Response: A realized gain is non-recurring in the income statement - it should not be capitalized into a maintainable earnings stream. But it is not fictitious. The cash is real and belongs in equity (or was distributed and belongs in the owner-comp/distribution analysis). Removing it from both places would understate value by $2.4M and is indefensible.
The discipline point: normalization has two separate jobs - (a) cleaning the earnings stream to a maintainable level, and (b) reconciling the balance sheet to economic reality. A non-recurring item is handled once, in the earnings stream, and then its balance-sheet effect is traced (reinvested? distributed? held as cash?). The owner is trying to get a double benefit: strip it from earnings (lowering the multiple base) and strip it from equity (lowering the asset base). That is a classic asymmetry play.
What to do: Trace the $2.4M. If it sits in cash/investments, it is a non-operating asset added to the DFC enterprise value. If it was distributed, it appears in the historical distribution schedule and informs the owner-comp normalization. Either way it does not vanish. Document the tracing in the workpaper.
3. If the valuation is used in litigation, what professional-standards obligations attach to the related-party adjustment and the working-capital finding?
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Related-party adjustment:
- Disclose the relationship, the absence of documentation, and the basis for the add-back. A reviewer or opposing expert will attack it; the workpaper must show you tested it (e.g., requested invoices, interviewed management, compared to market rates for the service).
- If you could not substantiate the services, say so and quantify the sensitivity.
Working-capital finding:
- Under-investment in working capital is a quality-of-earnings red flag. Disclose it, quantify the gap ($3.23M − $2.9M = $0.33M), and explain how it was handled (typically a normalization adjustment to the DFC or a note that the buyer will need to inject capital).
- Do not silently ignore it because it cuts against your client.
Litigation-specific:
- Independence and objectivity (AICPA/NACVA-style standards): the report must be understandable to a reader with no access to the workpapers. State the standard of value (fair value vs. fair market value), the premise (going concern), the as-of date, and the scope.
- Document all assumptions and the basis for each; a conclusion without a traceable path is vulnerable on cross-examination.
- If you are retained as an advocate rather than an independent expert, that changes the engagement - clarify the role in writing before signing.