We discussed what makes partner buyouts unique in a previous article which can be read here.
Normalizing financial statements is an important part of any business valuation, but it takes on added significance in a partner buyout. For purposes of this article, we are focused on SBA partner buyouts where one shareholder is buying out another shareholder, not partial interest valuations prepared for litigation or dispute purposes.
This article focuses on balance sheet and income statement adjustments that are particularly relevant when one owner is buying out another. Broader normalization adjustments apply in many valuation assignments and are discussed here.
A partner buyout is, in effect, a stock sale. The buyer is acquiring an ownership interest in the existing Company, which means the assets and liabilities of the Company matter. Unlike a typical asset sale, the balance sheet cannot be treated as an afterthought. We need to understand what remains with the Company, what is handled separately, and what should be removed from the analysis.
The purchase agreement is the roadmap for understanding what is included in the transaction, what is excluded, what will be paid off, and what will remain with the Company after closing. However, the quality of purchase agreements can vary. Some agreements are very clear, while others require additional clarification from the buyer, seller, or lender.
There cannot be a half effort when collecting financial information for a partner buyout valuation. Full tax returns should be provided, including all supporting schedules. The tax returns remain the controlling documents, but year-end internal financial statements should also be collected because they often provide more detail than the tax return balance sheets. That additional detail can help identify related-party balances, fixed asset issues, and other adjustments that may not be readily apparent from the tax returns alone. Current financial statements as of the valuation date are also critical, but they should be reviewed for accuracy before being sent to us. In a partner buyout, the balance sheet matters, and incomplete or inaccurate financials can materially impact the conclusion.
The depreciation schedule is especially important. In many SBA valuations, a separate machinery and equipment appraisal is not provided. When that is the case, net book value is often used as the value of the fixed assets under the asset approach. That figure also impacts the calculation of the fair market value of intangible assets, because intangible value is generally determined after assigning value to the tangible assets being transferred. Without a complete depreciation schedule, it can be difficult to identify what fixed assets are on the books, what may need to be excluded, and what net book value should be used in the analysis.
BALANCE SHEET
In a partner buyout, the balance sheet has to be reviewed carefully because the buyer is acquiring an ownership interest in the existing Company. In practical terms, most balance sheet items fall into one of three buckets:
• Leave it alone
• Treat it separately
• Remove it entirely
Some items remain on the balance sheet without adjustment because they are normal operating assets or liabilities of the Company. Other items may be treated separately as non-operating assets or liabilities, meaning they may still have value or require consideration. Finally, some items may need to be removed entirely if they do not represent a real asset or liability of the Company, will not remain after closing, or are otherwise resolved as part of the transaction.
The key is determining whether the item is part of the ongoing business, a separate non-operating item, or something that should not be included in the transaction at all.
ASSETS
Current Assets
Shareholder / Interrelated Party Receivables – A shareholder or related-party receivable represents money owed back to the Company by an owner, partner, shareholder, or related entity. These balances are often found in other current assets and are not always obvious on tax return balance sheets. In a partner buyout, they need to be understood because they may represent a real collectible asset, an informal advance, a prior distribution, or an amount that should be resolved as part of the transaction.
The question to ask: is this a real asset of the Company after the ownership change? If the balance is supported by a note, repayment schedule, interest, and actual payments, it may be appropriate to leave it alone or treat it separately as a non-operating asset, depending on whether it is part of the normal business. If repayment is uncertain, it may still have value, but only to the extent it is reasonably expected to be collected. If there is no repayment history, no note, no interest, and no expectation of repayment, it may need to be removed entirely because economically it may not be a true asset.
Fixed Assets
Furniture, Fixtures, & Equipment (FF&E) – Furniture, fixtures, equipment, vehicles, and other operating assets are usually found on the depreciation schedule. In a partner buyout, this schedule should be reviewed carefully because it may include assets that are not actually being conveyed in the sale, such as a selling owner’s personal vehicle, idle equipment, fully depreciated assets no longer in use, or equipment tied to another entity.
The question to ask: are these assets part of the operating business being transferred? If they are normal operating assets of the Company, leave them alone. If they remain with the Company but are not needed to generate the earnings being valued, treat them separately as non-operating assets. If they are not conveying, have been removed from service, or do not represent real value to the Company, remove them entirely. The depreciation schedule is important because it helps identify what assets are on the books and what net book value should be used when no separate machinery and equipment appraisal is provided.
Building & Land – Real estate should be reviewed separately from FF&E. In many SBA engagements, the operating business and the real estate are valued separately. However, in a partner buyout structured as a stock sale, real estate carried on the Company’s balance sheet may come with the transaction unless it is specifically carved out.
The question is simple: is the buyer acquiring the real estate as part of the ownership interest being purchased? If the real estate is part of the transaction, it should be addressed separately from the operating business. If it remains with the Company but is not part of the earnings stream being valued, treat it separately as a non-operating asset. If it is being removed, transferred, or handled outside the transaction, remove it entirely from the business valuation analysis. This also matters because rent expense may need to be reviewed if the business will operate from property owned by the selling owner or a related entity after closing.
Other Asset-Side Items to Watch For
Other asset-side items may include work in process, contract assets, prepaid expenses, deposits, book goodwill, intangible assets, or other balances that are not clearly classified elsewhere. These items are usually less common, but they should still be reviewed when they appear on the balance sheet.
Work in process or contract assets may be included in inventory or other current assets, especially in project-based businesses. Prepaid expenses and deposits may also appear in other current assets. Book goodwill or other intangible assets may appear in other assets and may relate to a prior transaction rather than current transferable value.
The question is simple: does the asset provide a future benefit to the Company after closing? If it does and is part of normal operations, leave it alone. If it has value but is not part of the operating earnings stream, treat it separately as a non-operating asset. If it relates to the selling owner personally, an asset not being conveyed, an agreement that will not continue, or book goodwill that does not represent a separately transferable asset, remove it entirely.
LIABILITIES
On the liability side, the main issue in a partner buyout is determining which obligations remain with the Company after closing and which obligations are being paid off, forgiven, assumed by the selling owner, or otherwise resolved as part of the transaction. Most ordinary operating liabilities do not require special treatment. The items that deserve closer attention are related-party debt and debt tied to assets that are not conveying.
Shareholder / Interrelated Party Loans – Shareholder or interrelated party loans represent amounts owed by the Company to an owner, partner, shareholder, or related entity. These balances may appear as notes payable to shareholders, loans from shareholders, due to related parties, officer loans, partner advances, or similar accounts. In a partner buyout, they need to be reviewed carefully because they may represent real debt, informal owner funding, seller financing, or amounts that will be resolved as part of the transaction.
Unless it is clear and obvious that the balance will be paid off within 12 months, these loans should generally be treated as long-term liabilities. The question is simple: does this liability stay with the Company after closing? If it is real debt that remains on the balance sheet, leave it alone. If it will be paid off, forgiven, converted to equity, or otherwise handled separately as part of the transaction, treat it separately. If it does not represent a real obligation of the Company, remove it entirely.
Debt Tied to Assets Not Conveying – Debt tied to assets not being conveyed should follow the asset. If a vehicle, piece of equipment, real estate, or other asset is being removed from the transaction, any related debt should be reviewed as well. We need to know whether the debt remains with the Company, is paid off at closing, or is assumed by the selling owner.
The question is simple: is the Company keeping both the asset and the debt after closing? If yes, leave it alone. If the asset is being removed but the debt will be handled separately, treat it separately. If the asset is not conveying and the related debt will not remain with the Company, remove it entirely. The asset and related debt should be treated consistently.
Other Liability-Side Items to Watch For – Other liabilities may include customer deposits, deferred revenue, unearned revenue, accrued compensation to owners, accrued bonuses, deferred compensation, or other balances that are not clearly classified elsewhere. These items are usually more fact-specific, but they should be reviewed when they appear on the balance sheet.
The issue is whether the liability represents a real obligation of the Company after closing. If it does, it may remain on the balance sheet. If it will be paid, waived, fulfilled, or otherwise resolved as part of the transaction, we need to understand how it will be handled.
INCOME STATEMENT
Unlike the balance sheet, most income statement adjustments in a partner buyout are similar to any other valuation assignment. The key difference is identifying expenses that will change because the selling shareholder is leaving the Company.
Officer Compensation / Other Salaries & Wages – Payroll is often the most important income statement issue in a partner buyout. These amounts are usually found under officer compensation and other salaries and wages. The objective is to determine the net change in labor cost after the ownership change. In plain English, how much compensation is going out the door, and how much compensation, if any, is coming back in?
We need to understand what role the outgoing shareholder had in the day-to-day operations of the business, what they were paid, and whether their duties will be absorbed by the buying partner, existing staff, or a new hire. This is often not black and white. A selling owner may work full-time, part-time, only handle key relationships, or only participate in major decisions.
If a new employee will be hired, the expected payroll cost should be provided. If the outgoing shareholder’s compensation is not clear from the tax returns or internal financial statements, that information should be provided separately. Without that detail, the payroll adjustment cannot be properly determined.
Rent Expense – Rent expense should be reviewed if the selling shareholder owns the real estate or if the ownership change will result in a change to the lease terms. We need o know whether rent will change after closing and whether the expected rent reflects a market rate.
Management Fees / Related-Party Fees – Management fees or related-party fees should be reviewed if they are paid to the selling shareholder or to an entity controlled by the selling shareholder. If these fees will stop, be replaced, or change materially after closing, we need to know.
The common thread in each of these income statement items is that the valuation analyst is not simply looking backward. We are trying to determine what the Company’s earnings will look like after the selling shareholder exits. If payroll, rent, management fees, or related-party charges will change after closing, that information needs to be identified before the valuation is completed.
Partner buyout valuations are not necessarily more complicated because the valuation methods are different. They are more complicated because the transaction structure is different. The buyer is acquiring an ownership interest in the existing Company, which means the balance sheet, related-party balances, fixed assets, debt, and owner-specific income statement items all need to be understood.
The goal is not to overcomplicate the process. The goal is to make sure the valuation reflects the business the buyer is actually acquiring. In a partner buyout, that means understanding what stays with the Company, what is handled separately, and what should be removed from the analysis.
When that information is clear at the beginning, the valuation process is cleaner, the report is stronger, and the lender is in a better position to understand the transaction.
Lance LeBlanc, C.V.A., is the President of Green Country Business Valuations, a firm specializing in SBA business valuations for lenders across the country. He has completed thousands of valuations and works closely with processors, underwriters, and lenders to support them through the underwriting process.
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valuations@greencountrybv.com