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Normalizing Owner’s Compensation
One of the most frequently encountered adjustments in business valuation is the normalization of owner’s compensation. The purpose of normalizing a business’ financial position and results of operations is not to restate the financial statements, but to help the valuator understand the true economic income of the business. Normalizing adjustments, such as owner’s compensation, can produce large earnings adjustments so it important that they be analyzed carefully. Consequently, the owner’s compensation adjustment is one that is often debated in adversarial proceedings.
Several factors contribute to owner’s compensation anomalies in a closely held company, which are not generally found in large private or publicly traded firms. For one, most small businesses are motivated to keep taxable income as low as possible at the business level. There is no pressure from outside stockholders and investors to show a profit and pay a dividend. In addition, the majority owner of a business usually has the discretion to set his or her pay based upon what the business can afford. In contrast, the owner of a non-controlling interest does not have the same ability to influence compensation amounts. Therefore, it may not be necessary to normalize owner’s compensation when valuing a non-controlling interest.
There are two components of owner’s compensation that are most relevant to the normalization adjustment analysis. The first is the amount of compensation that is in exchange for services provided by the owner. The second component represents compensation that is due to ownership in the form of profit distribution rather than services rendered. It is important for the valuator to get a good understanding of the roles and responsibilities of the owner(s). This understanding should be obtained through interviews with the owner(s) and other members of the company. One of the most critical areas of understanding is for the valuator to appropriately assess which responsibilities must be replaced if the owner no longer provided such services.
The valuator must determine reasonable compensation based upon replacement cost in the market. There are several sources of market data which provide such benchmarking information such as compensation databases and published surveys from industry associations and government agencies. Data can also be obtained from executive placement firms among other sources. It is important to note that a manager who has a controlling ownership interest has the ability to pay personal expenses through the business. These expenses are considered control adjustments and should be added back to the earnings of the business. Additionally, payments for traditional benefits such as medical, disability, life insurance, etc., that exceed industry benefit package norms are considered excess compensation and must also be added back to the earnings of the business.
In conclusion, the owner’s compensation adjustment can make a significant impact on the value of a business. It is up to the valuator to carefully analyze the facts and critically evaluate the appropriate compensation level.