How Business Owner Compensation Affects Valuation
Simply put, business owner compensation should not affect
business valuation. Or rather,
theoretically it should not. For small
and medium sized businesses, valuation is based on "Discretionary Earnings", which
includes "owner’s benefit". Owner’s
benefit includes one owner’s salary, health insurance, personal expenses run
through the company, etc. In other
words, the earnings (profit) that a company makes, plus the owner’s
compensation, is then used to determine the valuation.
It makes sense too.
Think about a company that has no earnings, but the owner pays himself
$500K a year in salary from his company.
Another company makes $100k in earnings and the owner pays himself
$100K. Which company would you rather
have?
But that is sometimes easier said than done. I’ve seen plenty of confusion and mistakes
when it comes to figuring out how to account for owner’s benefit. Let’s look at some examples:
Let’s say the business is a sole proprietorship. In this case the business financials will
appear on the owner’s personal tax return.
There will be no salary, as a sold proprietor doesn’t pay salary to
himself. So in this case there is no
salary to add back into earnings. An
owner can take a “draw”, but that isn’t salary.
The mistake I’ve seen is for a broker or owner to add draw back into
tax return earnings. For some small companies this
mistake can double the earnings and thus double the price of the business. I’ve never actually seen a business sold this
way, only priced this way until the error is discovered and the business
re-priced.
Another common error is how a working spouse is accounted
for. Often a spouse (yes, usually a
wife), works in the business but isn’t paid.
In that case, a fair working wage must be subtracted from earnings. That lowers earnings and lowers the price of
the business, but it is only fair since a new buyer would have to replace the
spouse with an employee – one which they will surely have to pay. Often a broker, not wanting to impact the
price, will "forget" to make that negative adjustment for the slave – uh, I
mean working spouse.
You’ll notice in the first paragraph the definition of
earnings is ONE owner’s salary. If a
husband and wife both work in the business and there is one line item for "Owner’s Compensation" then sometimes a broker will just add that back in. That isn’t at all correct since a new buyer
will again have to hire someone to take the place of the working spouse. The correct way to account for this is to add
it all back in, then do a negative adjustment for a fair wage to account for a replacement for the
spouse.
It can get complicated.
Let’s say an owner pays himself $200,000 a year, but has slowly moved
out of the company and now only checks in once in a while. His second-in-command essentially runs the
company now and he makes $90,000. A
new owner with the right qualifications could easily replace the
second-in-command. How do you price it? This is a tough one. You can add back $290,000, but you’ve now
priced it so a new owner almost HAS to fire the second-in-command for the
financials to work as advertised. I’ve
had a couple of these, and I sit down with the owner and fully explain the
situation. Does he wish to price it that
way? What is the relationship with his
top employee? Has he offered to sell to
the second-in-command? Could he? Would he like to provide some ownership to this
employee so he walks away with some money?
As you can imagine, some are deeply concerned about their employee and
work something out, and some see the sale of their business as their only
chance to build up their retirement and wish to maximize value at all
costs.
Actually, to be honest, I’d say all business owners say they
care about their employees, but sometimes – usually later in the transaction –
their actions don’t bear out what they told me earlier. Human nature I guess – and I’m less and less
surprised when this happens.
