HIDDEN BENEFITS IN THE COMPANY. The NON-ARMS LENGTH

What is normalizing benefits?

We call normalizing or adjusting the profit to the theoretical exercise of correcting the declared profit up or down and isolate the non-recurring items or items outside the activity of the company, in order to reflect a more accurate value of the company.

The seller should argue that his profits are greater than reported, whenever possible and credible. Each extra euro that the buyer of your company accepts as a hidden profit will exponentially increase the final price of the operation, in a proportion equivalent to the multiple offered.

What are the typical concepts that can be adjusted?

Extra salaries and bonuses of directors: We refer to those earnings which are above the market given the functions performed by said directors. It is a typical adjustment in family businesses and usually accepted by buyers, as long as we only compute the excess and not the entire amount of the over-cost according to the market.

An example would be the case of the Telefónica company, reducing salaries by € 250 million in 2020.

Extra costs for personal expenses: We refer to allowances, travel, cars, etc. that are not part of the activity of the company. These are also usually accepted by the buyer as more benefit. However, once the purchase and sale agreement has been reached, the buyer will want to make a guarantee reserve in the transaction price for said amount to cover contingencies (Reps & Warranties). In public companies they can be outrageous sometimes.

Rents paid above or below market: This is a peculiar case of which we will see below Non arms length transactions, but so frequently used that it deserves separate consideration.

In family businesses where an independent entity owns the properties and rents them out to the productive unit, these imbalances are typical. For example: Some companies with a good margin detract profits by paying a rent for their warehouses at 8% in industrial estates where no other activity could be carried out. It is a hidden benefit pending normalization.

The other side of the coin would be the case of car dealerships. The real state company rents to the car dealer, a low-margin business, at a below-market price to give it breathing space. This time the profit adjustment if the dealership is bought would be downward.

Adjustments for redundant assets: This is the case of CAPEX spent each year in excess, which in some cases is partially computed as repairs and maintenance.

This item will have to be normalized, particularly when the offer is on cash flow. This is the case of companies that invest more than necessary and / or in superfluous assets.

Start-up costs or unique projects: Here we find one off professional consultancies and fees, start-up costs for new lines or plants, brand launching, layoffs due to restructuring, removals, etc.

A debatable case in this section is that of an increase in salary and OPEX costs with the aim of long-term growth.

Other one-shot or non-recurring costs: Fines, penalties, lawsuits, inspections, etc.

Transactions at non-market prices (Non arms length transactions): This includes those items external to the company (basically purchases of services or products and commissions from third parties) which the target company buys at a higher price than the market price and / or those for which paying the same market price receives a deficient service or product.

In family businesses, they have been carried out historically in order to optimize the benefit between those close to the business (i.e relatives and close friends). An example would be hiring the maintenance service of the son-in-law's company, which turns out to be either very expensive or deficient because the contracted company does not assign the means required.

These transactions are detrimental to shareholders who disagree or are unaware of them. The further the recipient of the benefit is the more resources will be lost on the way. Thus, they usually generate a loss of money greater than the benefit they provide.

In public companies it carries severe penalties for unfair administration, embezzlement, illegal exactions, etc. The price of corruption in Spain is estimated between € 60 B and € 90 B a year, according to the IMF or the Greens, and much of it is articulated through these practices.

Compliance can control the contract prices, but it will be difficult to review the quality or the means awarded to the service or product behind them, even more so if we are talking about minor contracts or if the money is diluted along a chain of subcontractors. The existence of compliance is still rare in Spanish companies, although changes are expected in this regard.

Ultimately, convincing the buyer to adjust upwards the price to pay for surcharges in market transactions complicates the transaction, even more so if no mention of such surcharges was ever made in the audits carried out. In addition to requiring a solid argument on the part of the seller, buyers become uncomfortable and fill out the guarantee contract in the face of potential contingencies, especially foreigners buyers and funds. Sometimes they can abort the operation to avoid future responsibilities.

What to do to avoid normalization problems when selling?

Common sense must prevail between the parties when making adjustments.

On the one hand, we will apply a proportion criterion: the final normalized profit must be proportionate to the accounting profit. It will be difficult for the buyer to pay, based on adjustments, twice the company value calculated by a valuation based on accounting profit, unless there was a change in accounting rules and standards. The new valuation must be credible and the greater the adjustment and the multiplier the more solid and contrasted the justification must be.

On the other hand, we will assess a criterion of immediacy of synergies: Although the buyer is reluctant to adjust the profit upwards for something that he considers to be his own achievement (such as synergies), the reality is that depending on how easily these can be produced after acquiring the target, there should be room for negotiation. This would be the case of an automatic improvement in financial costs, in the event that the target company had a cost clearly above the market. Another case would be if the buying company is valued in the market at a higher multiple than the seller, with which the incorporation of the target's EBITDA would almost immediately lead to an increase in the Company Value.

A third criterion to consider is the perimeter in which the adjustment is located. The buyer usually accepts to normalize profits within the perimeter of the transaction, that is, within the companies that he buys, whereas going outside this perimeter would require more explanations.

A related transactions report, provided they are well justified, should help standardize and provide comfort to a third party. However, this would not be enough if the out-of-market transactions come from other unrelated providers.

In the case of a family business, the drafting and execution of a thoroughly carried out family protocol can save inconveniences and inefficiencies. It will be advisable to complete the team of lawyers with an economist who knows how to identify where the hidden benefits are (sometimes the family member himself wants to hide), determine their amount, and decide to what extent it is worth correcting it or leaving it as it is.

In the case of public or public-private companies, you already know what to do: control and a strong hand.