The Use of Organization Charts to Describe Normalization Adjustments

Written by Mark Norris

I was recently named an expert in a litigation case where I was required to testify about the valuation of a person’s equity ownership interest in a business. During the process, it became apparent to me how difficult it was for a Trier of Fact (whether that be a Judge or a Jury) to understand not only how normalization adjustments were calculated, but why they were required in the first place. I realized how valuable the use of an organization chart would have been to explain the need for the normalization adjustments contained in my report.  

Normalization adjustments represent adjustments to either the balance sheet or income statement of the company being valued. The ultimate purpose of these adjustments is to adjust the financial statements to more closely reflect its true economic financial position and results of operations (income statement) on a historical and current basis. One type of normalization adjustment represents an adjustment that converts an actual transaction to more accurately reflect an arm’s length transaction. Most of the time, these types of normalization adjustments are required when transactions take place between “related parties”. A “related party” would include any person or entity that is related to an owner, or owned in whole or in part by an owner of the company being valued. These adjustments can both increase or decrease the costs of the company being valued. It depends on the facts and circumstances of the expenditure being incurred and the related service or product being purchased.

In my case, services were being provided to the company by a relative of the owner in the form of CEO and COO services. In addition, accounting, technological and marketing/design services were being provided by a management company owned by this relative. The opposing expert erroneously took the position that since these services were provided by a “related party”, they were not ordinary and necessary expenses required to be incurred by the company in order to produce the good and services it produced. It was my opinion that, regardless of whether these services were provided by a related party, the company still needed someone to provide the services in order for it to be able to conduct its business. After hearing the opposing expert’s testimony, I realized how useful an organization chart would have been to substantiate my position.

As valuation experts, we must realize that most Triers of Fact don’t do what we do, and have significant difficulty understanding how a business runs, the related financial issues and how these issues affect the valuation of the business. The use of an organization chart brings to life the age-old adage, “a picture paints a thousand words”. An organization chart is an illustrative chart that documents the various departments and functions of a company. For instance, the President/CEO would typically be at the top of the chart. The various department heads would be listed below the President/CEO documenting who reports to whom, and what their function is. Some of these departments or functions would include operations, sales and marketing, human resources, accounting and finance, and technology.

I realized how effective a tool an organization chart would have been to just explain to the Trier of Fact how the business operated and what functions were required in order for it to produce the goods and services it produced. I really believe that taking the time to do that would have been greatly appreciated by the Trier of Fact at the beginning of my testimony.

Even more importantly, I believe that the use of an organization chart would have helped me document why the opposing expert was in error when he eliminated all expenses for services that were provided by the management company, simply because it was a related party. For example, I would have explained to the Trier of Fact that the company only employed people in the operations area of the company. The company did not employ people to provide all other functions and related services illustrated on the organization chart including the President/CEO, COO, sales and marketing, human resources, accounting and finance and technology. Therefore, a logical question I would have proposed would have been: how can the company operate without these services, which was the position of the opposing expert? Once I was able to demonstrate the need for these services, then I could demonstrate that the company would have to incur costs for these services, i.e., the need for normalization adjustments to account for these costs based on market, arm’s length rates.

In conclusion, I would recommend all valuation experts to consider the use of an organization chart to help document not only how the company being valued operates, but also use this tool to support the need for certain normalization adjustments . Furthermore, I would recommend any attorneys involved in litigation who use the services of valuation experts to suggest to their valuation experts the use of organization charts in their reports and if applicable, their testimony at trial.

This article was also published in A BVR Special Report (Business Valuation Resources), featured in Chapter 4.