Whenever a business/practice (“business”) is being prepared for a sale, one of the most important “normalizing adjustments” is the owner and family compensation.
The task is to figure out how much it would cost for new owner/management to take over the tasks of the outgoing owner/management. Sounds like it would be pretty easy to do this, right? Just take out the current owner’s salary, throw in a replacement salary for the buyer (maybe even the same amount) and it is done!
However, as with most things in the valuation/transaction world, it is usually not that easy. Business owners can be paid a substantial salary or almost nothing, can work long hours or not at all, and can be easily replaced or almost irreplaceable.
Owner’s Compensation Considerations
Below is a list of some of the items that valuators consider before calculating normalization adjustments:
- How Much Was the Owner/Seller Paid? – This seems simple (just look at the W-2), but owners can be paid through 1099s for commissions and rebates, or through guaranteed payments that are shown on K-1 forms. Also, some owners are “compensated” through large pension plan payments or high insurance.
- How Many Hours per Week Did the Owner/Seller Work? Many owners do not work a standard 40 hours per week. We have seen a range of hours from zero (completely absentee) to cases where owners work the equivalent of two jobs for 80 hours per week.
- How Easy/Costly Will it be to Replace the Owner/Seller? – If an owner works very long hours at difficult tasks, is a specialist in the field or has a close, long-term relationship with customers/vendors (a high degree of personal goodwill), he/she may be very difficult to replace.
- Multiple Owners – Need Information on All of Them! If there are multiple owners, the above three questions need to be asked for all of them. And the answers could vary significantly. Some may be staying on after a sale, some may be critical to the business, and some may only do basic administrative tasks.
- Family Members Who are Not Owners – Another issue can arise when family members work for the business. Are they paid at market rates? Would they need to be replaced? Sometimes, family members are paid just enough to earn income for IRA contributions, but do not do any meaningful work for the company. Sometimes, they may hold important positions in the business that would be difficult to replace, especially when the owner is older and semi-retired.
- Reasonable Market Salaries – A valuation analyst also needs to determine reasonable market rates for all the salaries that would need to be replaced. Sometimes a provision needs to be made for a partial salary (say 20 hours per week) and sometimes two salaries would cover one person (if an owner works 80 hours per week). We have various sources of salary information, but before searching for these salaries, we need to know what we are replacing.
Clearly there are many things to consider when preparing normalization adjustments. Normalizing owner(s) and family compensation is one of the most important “normalization” adjustments when preparing your business for sale.
