You’ve probably heard the story about this Kansas farmer. A sales rep shows up at the farm and pitches a new machine. “This one is so good,” the rep brags, “it will do half your work!”
The farmer doesn’t blink. “Great! I’ll take two of ‘em!”
We are living through an unprecedented time in the history of automation. Wall Street has applied a new lens to the software sector over the last year in recognition of the power of AI. (This new lens is not necessarily to the benefit of software stockholders!) Automation can reduce the burden of administration and speed up some of the work we do. Incredibly, we seem to experience improvements nearly every week.
In this push-button era, it can be tempting to believe that if automation can calculate ratios and apply formulas, it can also handle the tricky judgment calls required in the valuation of privately held businesses. In my experience, there are at least two common normalizations that automated tools do not handle well:
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Owner compensation
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Rent normalization
Owner compensation and rent look simple on a financial statement. They are not simple in valuation. These adjustments require context, thought, consideration, and judgment. These issues come up in almost every valuation, and when they are not handled well, results are compromised.
Let’s take a look at owner compensation.
In an ideal world, a business owner is compensated in two distinct ways. First, they should draw a payroll salary commensurate with their actual day-to-day operational role in the company. Second, they should receive a reward for having the vision, executing the strategy, and taking the underlying entrepreneurial risk. Ideally, that second bucket is paid out via distributions or dividends.
Of course, in the real world, the compensation of business owners will be based on how they optimize for taxes, how they feel most comfortable, and how the cash flows of the business support the timing of those payments.
Sometimes, owners take all rewards, including ownership rewards, as salary. Maybe some of those dollars that appear to be salary are actually profits. This is perfectly legal and legitimate and there can be good reasons to do it this way. However, a machine reading that tax return will likely take it at face value, completely understating the company's baseline cash flow and driving an artificially low valuation.
Often, we see the exact opposite. Sometimes, owners take very low salaries, especially later in life. On paper, as read by automation, the business then overstates profitability at the bottom line. Unless an analyst catches this and adjusts that wage upward to a real-world replacement cost, the automated tool will spit out an artificially inflated value.
Add multiple owners into the mix—some active day-to-day, some purely passive—and the data gets even muddier. Even "simple" metrics like Seller’s Discretionary Earnings (SDE) get completely thrown off here. A common valuation pitfall is the inclusion of multiple owners wages in an adjustment to the SDE line. Technically, only the highest-paid single owner's wage should be adjusted. Automated tools struggle to untangle these multiple-owner benefit streams in a vacuum.
It is not possible to understand the value of a business without understanding true cash flows, and it is not possible to understand true cash flows without understanding the entire, sometimes messy, picture of how owners are compensated….or, sometimes, NOT compensated.
Rent normalization can also bring up similar issues.
Imagine a business that owns the building in which they operate. They might have no rent payment whatsoever. This will almost certainly not be true for a Fair Market Value buyer. Either: 1) they will buy the business, not buy the building, and pay rent to the owner, or 2) they will buy the business, buy the building, and then have debt service on the building that the current owner does not have. Either way, with no adjustment, cash flows are overstated.
The opposite can be true. Often, the building is owned by a related-party entity. Sometimes, the rent is paid far in excess of market rates or required debt service. Overpayment of rent will understate the cash flows.
More often than not, automated tools will overlook these intercompany dynamics entirely—unless the professional operating the software actually knows what to ask.
We ask questions about these issues in our standard Blue Owl diligence questionnaire. Often, we get an answer to the effect of, oh, we own the building and we’re not selling it. We’re only selling the business, so this doesn’t matter.
But it does matter. Fortunately, this exchange gives us the exact diagnostic flag we need to review the leasehold reality, and understand the true economic baseline.
Automated tools can identify certain trends. They can calculate ratios quickly. They do many things well. But business valuation is absolutely NOT just a math problem. Some of the most important adjustments require the analyst to have a deeper understanding of who is being paid, how they are paid, and what this looks like through the lens of Fair Market Value.
When I think about that Kansas farmer in story, I picture the farmer with a look of knowing sarcasm on his face. The way I imagine the anecdote, the farmer is intentionally egging on the machinery rep just to see how far the pitch will go. You can almost see the sales rep stammering, “...well... uh... sir... I’m not sure buying two would actually...”
Then the farmer laughs, the rep laughs, and they both move on because they knew better all along. To me, that’s the whole point of the story.
Automation carries great promise, and we should use it, when possible, to clear the administrative brush. But don't let the shiny promise of a push-button solution distract you from the non-negotiable requirement of deeper understanding and experienced professional judgment.
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