Reasonable Compensation and Its Effect on the Value of a Business by Scott Bouchner, CMA, CVA, CFE, CIRA, and Sharon F. Foote, ASA, CFE
Over the next two decades, millions of business owners will sell or transfer several trillion dollars’ worth of privately held business assets. Proper valuations of these entities using an asset approach, an income approach and/or a market approach will provide worthwhile information to both buyers and sellers. However, when using the income or market approaches to valuations, it is important to first normalize a business’ financial statements in order to estimate future expected cash flow that a potential buyer can reasonably expect to receive in return for his or her investment.
The International Glossary of Business Valuation Terms defines normalized financial statements as those “adjusted for non-operating assets and liabilities and/or for nonrecurring, noneconomic, or other unusual items to eliminate anomalies and/or facilitate comparison”. Such a normalization process requires a business’s valuation to present information on a basis similar to that of other companies in its peer group and in benchmark studies used for comparison and analysis. One of the most common normalization adjustments utilized in valuing closely held companies is officers’ and owners’ compensation.
The purpose of making a compensation adjustment is to remove any distortion of the company’s operating performance caused by compensation and/or perquisites paid to its management team. To reflect a realistic or reasonable value, the valuation professional “normalizes” the company’s cash flows to reflect what buyers can potentially expect to be available to them.
However, the U.S. Tax Court has been examining officers’ and owners’ compensation for decades because the compensation structure of smaller, privately held companies are often less structured and more flexible than that of larger and publicly traded companies. Owners may pay themselves or those related to them higher or lower salaries, or they may provide other forms of incentives and noncash compensation in order to reduce tax liabilities, improve cash flow or business value, or simply to retain cash.
For example, business owners may reallocate income and essentially misrepresent business value when they do any of the following (as well as other actions not mentioned here):
- Move income to a close family member who is in a lower tax bracket or who does not actually do any significant work for the company;
- Book deferred compensation;
- Receive income in another form, such as rent for company facilities held in a separate entity; or
- Book loans to the company, which could be considered compensation.
In the context of performing a valuation engagement, owners’ or officers’ compensation must be normalized to reflect the salary and benefits an outside third-party would be paid to fill the same position. To arrive at a normalized compensation figure, valuation analysts would commonly examine the following:
- The skill set, education, qualifications and experience of the employee;
- The employee’s duties, the nature, the scope and the time required to do them;
- The complexity, size and geographic areas serviced by the business’ operations;
- The condition of the economy and industry the business services; and
- The salaries, bonuses, benefits and/or other perquisites paid to employees doing comparable jobs in similar businesses in the same geographic region.
To determine if perquisites are at a normal level (for an outside employee), business analysts must evaluate specific items, such as (1) automobile expense allowance, (2) tuition reimbursement, (3) country club and other membership fees, and (4) insurance (health, life, or other types) and retirement benefits. If excessive, these types of expenses would need to be normalized as well. Analysts must also consider the cost to replace the current owner or officer. Locating a replacement employee could require a long and potentially expensive search as well as a costly signing bonus and/or placement agency fee.
To benchmark what a reasonable range for total compensation may be, valuators will often turn to trade associations, specialty consulting firms or other industry groups that often make this type of data readily available. Among the more popular resources are the Bureau of Labor Statistics and the RMA Annual Statement Studies. Data can also be found on the Internet, at websites such as salary.com, or in the SEC filings of publicly traded companies that may be used as reasonable comparison for the company being valued.
Compensation adjustments can have a significant impact on the value of a business, especially if the business’s value is calculated under an income or market approach using revenues and/or earnings. For that reason, normalization adjustments, such as owners’ and officers’ compensation, must be carefully considered.
About the Authors: Scott Bouchner, CMA, CVA, CFE, CIRA, is a director with Berkowitz Pollack Brant’s Forensic Accounting and Business Valuation Services practice, where he has served as a litigation consultant, expert witness, court-appointed expert and forensic investigator on a number of high-profile cases. Sharon F. Foote, ASA, CFE, is a manager in the Forensics and Business Valuation practice. For more information, call (305) 379-7000or email email@example.com.