By Jasmina Woodson, Withum
As business appraisers, we often have conversations like this:
Business Owner: These amounts were actually paid! Aren’t I entitled to make decisions regarding my company’s operations that will benefit me?
Appraiser: When it comes to business valuation, not exactly…and here is why.
A key step in preparing a business valuation under the Income Approach to value is determining the income stream a business would earn if it was managed by an independent party whose objective was to report the highest amount of earnings for the business. We call these earnings “normalized earnings”. Often, in matrimonial matters we deal with the owners of closely held businesses, whose goal is to lower reported earnings in order to reduce taxes. Because these owners typically have the discretion to adjust the operations of the business to achieve their goal, the appraiser must assess the business’ financials (tax returns, financial statements, detailed general ledgers, etc.) to determine what, if any, adjustments are needed to normalize earnings (i.e., what the company would have earned if managed by the unrelated party described above). Some of the more common normalization adjustments are reasonable compensation, personal expenses (perquisites), unreported income and expenses, and extraordinary or non-recurring items.
However, when valuing the subject interest of a business the appraiser must also consider all related party transactions. One such transaction is rent for the business premises. Most businesses need to rent space for operations or at the least, storage. There are instances, particularly with closely held businesses, in which this property is owned by 1) the business itself, 2) one or more owners of the business, either personally or through a real estate holding company, or 3) a related party of one or more of the business owners (i.e., relative, friend, business partner, etc.). In any of these situations the business appraiser has to assess if the rent paid by the business is at the market rate. For many reasons it may be above or below what is considered market rate. The following examples illustrate some of the motivations for business owners not to pay market rate rent.
As discussed above, for tax purposes the owner(s) of the business may increase the rent expense to reduce reported earnings.
The mortgage and expenses related to the property exceed what would be collected as rental income using market rate rent. As a result, the business pays an inflated rent expense to cover any shortfall.
The business is not earning enough to pay market rate rent; thus, the rental expense is reduced.
In order to calculate the normalized earnings, when the business is not paying market rate rent because the property being leased is owned by a related party or entity, the appraiser should consider making a normalization adjustment. To effectuate this market rate rent adjustment the appraiser typically relies on the following sources of information:
Real Estate Appraisals - The real estate appraisal performed by an independent third-party real estate appraiser may contain the market rate rent for the property. This information is available if the real estate appraiser considered an income approach in their valuation.
Lease Agreements with 3rd Parties - Another source of information is a lease agreement with an unrelated party. If the property has multiple occupants and one or more are unrelated, the lease agreements with those tenants can be used as an indication of the property’s market rate rent.
Online Data –The appraiser can also perform a search of reputable websites for the rental rates of comparable properties to determine the market rate rent based on the square footage and type of space utilized.
So, overall, how does the market rate rent adjustment impact your client? Without considering any of the other factors that go into preparing a business valuation, if the business owner is paying rent in excess of market rate, then an adjustment to market rate rent will decrease expenses and increase earnings and the value of the business. Conversely, if the business owner is paying less than market rate rent, then the adjustment will increase expenses and decrease earnings and thus, lower the value of the business.
What is a Market Rate Rent Adjustment?
The market rate rent adjustment is a normalization adjustment used when preparing business valuations in which the company pays above or below market rent to a related party or entity.
Why do appraisers make this adjustment?
Using the Income Approach to value, the market rate rent adjustment is made to normalize earnings so that the earnings represent those of a business managed by an independent party whose goal is to maximize profits.
How does this adjustment impact the business valuation?
With all other factors of business valuation remaining constant, if the business is paying more than market rate rent, the adjustment will result in an increase in earnings and an increase in the value of the business. If the business is paying less than market rate rent, then an adjustment will result in a decrease in earnings and a decrease in the value of the business.