How Do Business Valuation Professionals Estimate Reasonable Compensation

Key Takeaways:
  • Aligning executive compensation with market standards is important to ensure an accurate business valuation and maximize profitability.
  • Normalizing compensation helps potential buyers assess realistic cash flow and future salary expenses, impacting the company’s value.
  • Business owners can prepare for a smoother valuation process by researching and implementing market-rate compensation before selling.

 

Is there such a thing as being paid too much or too little if you own the business? If you are planning to sell your business, that might just turn out to be a problem. 

When a business is undergoing an independent valuation prior to merging or being sold, one of the factors taken into consideration is the amount of compensation being paid to top executives, particularly the owner. If the compensation is misaligned with that of executives at comparably sized companies in the region – either too high or too low – the valuation professional may need to make “normalizing adjustments.” 

Normalizing adjustments are made by backing out any excess compensation from the company’s pay structure. The numbers are then normalized by substituting a realistic level of compensation, which helps the valuator reach an accurate conclusion about the company’s profit margin. Ultimately, this gives a potential buyer a more realistic view of the company’s future compensation structure, salary expenses and cash flow. 

Excessive owner compensation – or conversely, low compensation – often happens in smaller companies and family-owned companies, where owners are free to set compensation levels they want in order to support lifestyles. In some cases, salaries may be reasonable, but perks such as cars, country club memberships, travel and even private airplanes can push pay packages significantly above typical levels. On the other hand, family owners who have always counted pennies and plowed profits back into the business may actually be underpaying themselves. 

Determining Proper Compensation 

To determine the proper range of compensation, valuation professionals may research executive pay at comparable companies either in the same geographic region or in the same industry, or both. They also may ask the owner of the company how much they would pay a new executive who was hired to replace them. This would assume the replacement would have the same duties and responsibilities.  

Normalizing executive pay may also involve comparing certain metrics with similar companies, such as the composition of officer compensation as a percentage of total sales of the company. Larger companies typically offer better compensation packages that may include stock options and other types of bonuses. All of these factors are considered by valuation professionals as part of the normalizing process. 

What happens if there are no comparable companies to use as guideposts? In less populated areas of the country, this can be a problem. Valuation professionals sometimes consult web-based salary information sites such as Glassdoor and Salary.com. While these sources are not infallible, they provide some usable data. Valuators also sometimes ask their own human resources teams to do some background research to help produce reasonable compensation figures. 

The conversation about compensation normalization with a business owner who is looking to sell can be sensitive, particularly when it is being exposed in the valuation professional’s final report. So, every effort is made to ensure that the salary data is as accurate and fairly presented as possible. But the bottom line is that the business valuation report must include an accurate profitability statement for the business. If the current executive compensation is excessive, normalizing it improves the company’s profitability numbers and impacts cash flow, thereby impacting value. 

What Should Business Owners Do? 

If you are considering obtaining a business valuation within the next two or three years as a first step toward exiting your company, there is one important preliminary step you can take today: 

  • Do some research to determine what the market rate compensation is for owners and executives at similar companies in your industry. Think about what you would pay an executive if you had to be replaced today. Then implement your findings. This will help the eventual valuation process go more smoothly, and may help maximize the value of your company. 

Excessive executive compensation can impact your company in several ways – by limiting profitability and growth, depressing cash flow or keeping you from making needed capital expenditures. Getting on the right track today can help you in the immediate and long-range future. 

This exercise can also help de-risk your company if there are several minority shareholders and the majority shareholder is actively involved in the business thereby drawing a salary for their contribution. By documenting comparable salaries or asking the company’s human resources team for additional input, along with good corporate governance, you are insulating the company from a minority shareholder dispute.  

If you would like to discuss executive compensation at your company and its impact on valuation, contact an Adams Brown advisor.