“How much I make is none of your business!” This is a phrase valuation experts sometimes hear, particularly when gathering information in contentious domestic relations matters. Some business owners feel that when a valuation expert asks them how much they make (and how much they would pay someone else to do their job) that the valuator has crossed a line. “You’re being too nosy – you don’t need to know how much I make to tell me how much my business is worth.” The typical business owner’s response is not unreasonable – although we live in a society in which we broadcast loads of information about ourselves to the public (Facebook, LinkedIn, Twitter, etc.), our compensation is one of the last pieces of personal information that is still closely guarded. Most people do not realize, however, that adjustments related to owners’ compensation often play a significant role in reaching an appropriate conclusion of value for ownership interests in privately-held companies.
If you and I ran absolutely identical businesses (same historial and projected operational activity), but you took out $100,000 in annual compensation while I took out $200,000, whose business is worth more? The answer is (assuming for the sake of the discussion that both businesses are identical) – they have the same value. See below for the proof:
In many valuations, it is necessary for the valuation analyst to make normalizing adjustments for certain items in order to better reflect economic reality. One of these adjustments is typically for owners’ compensation. While $100,000 may be the fair market value for the services provided by each of us, I may have chosen to pay myself an additional $100,000 since I have control of how my company’s funds are used. This does not make my business any less valuable than yours; it simply means that I am paying myself more in compensation rather than directing these funds to myself through a dividend/distribution from the company.
When a valuation expert is probing about 1) how much a business owner pays himself/herself; and 2) how much the business owner would pay a third party to perform his/her job, it is because this information, used in conjuction with resources that valuation experts have regarding approximate owners’ compensation for similar companies/positions, allows them to arrive at a reasonable normalizing adjustment for owners’ compensation (if one is necessary at all).
For anyone hesitant to provide a valuation analyst with their compensation information, remember that we are bound by our professional standards not to communicate that information to anyone outside of the engagement. It can be a critical piece in the valuation puzzle – we are not trying to be nosy, we are simply trying to gather all of the pieces of information necessary to reach a supportable conclusion of value.
If you have any questions about this article, post a comment below or please contact our Business Valuation Services at 440-449-6800.