By Paul S. Hamann & Jack Salewski, CPA, CGMA
Defining reasonable compensation is a fairly simple task. According to Black's Law Dictionary, it is, "compensation which is consistent with the normal reward for any employee for the work performed or duties that are involved." However, that definition is not as simple as it may appear. A key word jumps out to any business valuator or reasonable compensation expert – normal. What is a normal reward? What is normal to one may not be normal to another. The compensation for any job title can vary by industry, location, and experience. Normal is a relative term, making it all the more challenging to determine reasonable compensation.
In this newsletter, we'll discuss the dangers of not normalizing reasonable compensation when valuing a business, the three approaches to reasonable compensation, and the challenges of using antiquated techniques in determining reasonable compensation.
As a valuator, you need to normalize reasonable compensation to complete your engagement successfully. Owners, and in particular owners of closely held businesses, will often adjust their salary to maximize their business's profitability or minimize tax burdens. The challenge when performing a valuation on these businesses is determining what normal compensation is for the owner, not the salary they are choosing to pay themselves.
Take one of our recently published Case Studies. Matthew Cassedy, a veteran business appraiser, was brought in by the wife in a divorce. Both the husband and wife were lawyers, but the husband was the single-owner of a medium-sized law firm. The valuation he produced used the market approach, resulting in his salary being extremely high, leaving the business (a shared asset in the divorce) with no enterprise goodwill. Mr. Cassedy was brought in and was able to produce a far more reasonable normalized figure for the husband's compensation.
In this case, the divorce went to mediation. The wife was able to use Mr. Cassedy's reasonable compensation report from RCReports to walk the mediator through exactly how the number was calculated. This led the mediator to provide a more equitable value on the husband's business, allowing the wife to receive a fair settlement for her share in the business. Normalizing the husband's reasonable compensation and providing robust documentation helped Mr. Cassedy present a reasonable compensation figure that was realistic and defensible.
The Three Approaches
The Case Study of the divorcing lawyers points us to yet another danger in the valuation field. Most business valuators utilize the market approach when determining reasonable compensation for a closely held business owner. The husband's valuator simply used the market approach, assigned his client the title of "CEO" and looked at other law firms. However, not all CEO's are the same. Many business owners have this title despite the fact that they perform multiple functions. In our example, the CEO of a law firm is likely still representing some clients. He may also be involved in HR duties, office management, and myriad other tasks.
Understanding which approach to use for determining reasonable compensation is crucial for an accurate valuation. Here's a quick breakdown of each approach and when each should be utilized.
- The cost approach looks at the different tasks an owner may complete in their day-to-day business operation and apportions their time and skill for each task. In the case of our divorcing lawyers, this may have been the more appropriate approach since although he held the title of CEO, he likely engaged in multiple other tasks.
- The market approach compares the compensation a non-owner would be paid for the same position at the company. While this often works best for owners who only do one job at their business, it is important to make sure they aren't performing additional tasks that might raise or lower their compensation.
- The income approach determines whether a hypothetical investor would be satisfied with their ROI when looking at the financial performance of the business in conjunction with the performance of the owner. This approach is very specific to owners whose achievements are outstanding or for whom little to no comparability data exists.
The Good Old Days
You don't have to be that old to look back and remember the trials of determining reasonable compensation before tools such as RCReports came around. You used to have to search high and low to find comparability data, consulting a mélange of websites and databases. If you were lucky, you could find something that was relatively comparable – similar job titles or equal levels of experience. Those were rare days, though, and even then, you had trouble knowing exactly where that data was gathered. It was ultimately a frustrating, long, and inexact process and, to think, this was just a few years ago! We dare not mention those dark and scary pre-Internet days of reasonable compensation calculations.
There are two major problems with using antiquated resources in calculating reasonable compensation. The first is that they are time-consuming. Having to search through different databases to find a decently representative sample can be, at best, irritating. At worst, you spend hours or days finding comparability data that is weak and non-specific. The second challenge comes if you need to defend your compensation figure. Where did the data come from? What methodology was used? What were the quality controls? How frequently are the salaries updated? If you can't answer these beginning questions, your reasonable compensation figure certainly won't withstand a challenge from another valuator, the IRS, or a court.
As we've seen from our divorcing lawyers, normalizing reasonable compensation figures is an important element of business valuation. Owners of closely held SMB’s can, and will, try to adjust their compensation to maximize their tax benefits or avoid a costly divorce. It's important that when you're completing a valuation, you provide a reasonable compensation figure that is calculated using the right methodology and supported with robust data that can withstand a challenge.
P.S. We are conducting a Reasonable Compensation Market Study for Valuators so we can continue to fine-tune RCReports for you. Please visit RC & Valuation. Takes about 10 minutes and we will share the results with you in July!