Challenges with Adjusting Owner Compensation When Valuing a Business
Written by: Jay Sickler, CPA, CFF, ABV, ASA
At Cogence Group we value closely held businesses, not public companies. Closely held business owners often pay themselves significantly above or below market-based compensation benchmarks for a variety of reasons. It is up to us to figure out whether compensation is reasonable when valuing a company, because the level of compensation directly impacts profitability, which drives the company’s value. This is not an easy and straightforward math exercise, as considerable business valuation expertise and experience is necessary. In order to address whether, and by how much, owner compensation needs to be adjusted, the appraiser needs to consider the following:
1)the purpose of the valuation
2)the standard of value
3)whether the subject interest is a minority or controlling interest
Purpose of the Valuation
The purpose of the valuation is important in determining whether an adjustment should be made to owner compensation. For example, if the valuation is for marital dissolution purposes, the court may expect that the owner-spouse’s compensation be adjusted to market in order to arrive at an appropriate fair market value for the company as a whole. If the business is being valued for a potential sale to an outside buyer who will not need to replace the owner-seller, the seller may want to eliminate their compensation, increasing profitability, and thereby increasing the potential sale price. If the owner wants to sell the business to some key employees but also wants to continue to work in the business for some period of time, the compensation may be increased or decreased to reflect the parties’ expectations about future contributions by all stakeholders.
Standard of Value
Our profession defines various standards of value which directly affect the way an appraiser values a business or ownership interest in a business. The most commonly defined standard of value is “fair market value.” This standard of value assumes a hypothetical willing buyer and seller. “Investment value” is different than fair market value as this standard of value contemplates a specific buyer and seller. Fair market value is the standard of value in all transfer tax valuations filed with the IRS. Investment value is appropriate when attempting to establish value or price for an M&A transaction.
Under fair market value, the hypothetical buyer and seller is expected to negotiate a price assuming owner compensation is at market. This is because the seller will try to maximize price by arguing that the market compensation for their services is lower than what they are being paid, while the buyer might argue that the owner's (seller’s) services cannot be replaced for the amount currently being paid. Under investment value, the owner’s services, and therefore compensation, might be assumed to be redundant (negotiated by the seller), or be expected to increase to add extra skill and experience (negotiated by the buyer). It is easy to see how these two different positions have a push-pull impact on value/price.
Minority vs. Control
Under our professional business valuation standards, the size of the ownership interest being valued directly impacts the consideration of adjustments to owner compensation. For instance, it is common for appraisers not to adjust owner compensation when valuing a minority interest because a minority interest holder cannot lower the compensation of the majority shareholder(s). This lack of control is reflected in the cash flow as it exists. However, what if an owner is paying themselves significantly above or below market? In our practice, if we are determining fair market value, and a controlling interest holder is paying themselves significantly over market, we will adjust the compensation to market to recognize the threat that a minority shareholder could bring a shareholder oppression suit against the company and majority shareholder. Conversely, if a controlling interest holder is paying themselves significantly below market, we will also adjust the compensation to market to recognize the fact that a controlling shareholder could at any time increase their compensation to market, thereby reducing profitability and value.
A good appraiser should play out in their mind the willing buyer and willing seller negotiating across an imaginary table. The hypothetical buyer and seller under fair market value will look different than the specific buyer and seller in an M&A transaction. It may be assumed that the hypothetical buyer and seller expect that the business will continue as it is or has been. In the M&A transaction, the seller often wants a higher price because of the perceived added profit the buyer will earn in the future because of increasing revenue or eliminated costs (like their compensation). However, the buyer may not be willing to pay for any of the perceived enhanced value, because it is the buyer who must change the business to make that happen, not the seller.
As Cogence Group has seen in its 30+ years of experience, adjusting owner compensation is an important yet challenging element of business valuations. It is critical that when completing a valuation, the appraiser assesses owner compensation and understands whether any adjustments are calculated using sound methodology and supported with robust data that can withstand a challenge. At Cogence Group, our experience helps us deliver a supportable and unbiased valuation. Count on the experience you can trust.