When a business is valued, owner compensation is likely to come under the microscope. Generally, valuators consider only “reasonable compensation” — that is, the amount the business would need to pay a non-owner to provide comparable services. This article goes into the details of this important process.
One of the perks of owning a closely held business is controlling the purse strings when it comes to compensation. An owner might take an artificially large salary to reap tax benefits or a smaller salary to enhance the company’s earnings. But when a business is valued — for sale, divorce or other purposes — owner compensation is likely to come under the microscope. Generally, valuators consider only “reasonable compensation” — that is, the amount the business would need to pay a non-owner to provide comparable services.
Valuators examine a variety of factors in determining reasonable compensation for a particular owner, including:
Role/job description. Valuators look beyond the owner’s title to the actual roles he or she fulfills. If the owner of a small business truly functions as CEO, CFO, COO and salesperson, the compensation should reflect all of those roles. On the other hand, if the owner is CEO in name only, and an employee handles most of the related duties, the compensation will be downgraded.
Valuators also determine the qualifications necessary to perform the owner’s job. What training, education, licensing and experience are truly required? A master of fine arts degree may be impressive, but it likely isn’t relevant to compensation in a business outside the art world.
External comparables. Valuators may also use compensation surveys to compare an owner’s compensation to that of similarly situated employees at similar companies. Sources of compensation data have proliferated in recent years and include the Bureau of Labor Statistics, the Economic Research Institute, numerous Web sites and corporate recruiters. When using compensation surveys, it’s critical to understand the structure of the compensation under comparison to ensure you’re comparing apples to apples. For instance, does it include benefits? Stock options? Taxes?
Internal comparables. An owner’s compensation can also be compared to compensation of non-owner employees within the business. If the company consistently pays above-market rates for other employees, an above-market rate for the owner becomes more acceptable. Ideally, the business will employ a rational and consistently applied
compensation formula for every position.
Company characteristics. A business’s size, industry, competitive position, financial standing and history all affect the reasonableness of compensation. Companies that boast high sales numbers generally can afford (and justify) high compensation, but size isn’t necessarily determinative. Companies with larger market share often pay well to prevent employees from jumping ship, but smaller companies may also pay handsomely to poach those same employees.
Industry characteristics. Reasonable compensation for an owner may further depend on the industry’s economic conditions and cycle, as well as the availability of comparable employees.
Location. A technology company in Silicon Valley will have greater access to comparable employees than a similar company in Montana. Cost of living also plays a role: An owner in New York City requires more compensation than an owner in Topeka to maintain a similar lifestyle.
To each, its own
Every business is different, and the decisive factor that drives the reasonableness of owner compensation may be one not listed above. Evaluating owner compensation requires a fact-intensive inquiry and an open mind.