How Shareholder Compensation Affects Value
We deal with a wide array of valuation engagements in which shareholder compensation becomes a sticking point.
In some instances it is proper to adjust shareholder compensation as part of adjustments to the financial statements. This change will more often than not have a direct – and often material – impact on the calculated value of a company.
With that in mind, you can imagine that it’s often a bone of contention.
Why Adjust Compensation?
Oftentimes a working shareholder will use their salary as a mechanism to withdraw profits from the business. The W2 compensation thus reflects not their actual contributions to the business as an employee, but rather their stature as a shareholder. For businesses with a single shareholder (or perhaps a small group), the owner doesn’t draw a distinction between salary and dividends: it’s all the same pile of money from which he or she can pay themselves.
Take for example a company with $2.5 million in revenues and $100k in earnings, and a single shareholder that takes a salary of $1 million (“Scenario 1” below). That same shareholder might choose to pay themselves a salary of $100k and receive the rest as a dividend. In both cases the cash available to the shareholder is the same. Makes sense, right?
|Scenario 1||Scenario 2|
|Available to S/H||1,100,000||1,100,000|
So What’s the Big Deal?
Valuation is most frequently a function of earnings. And if that’s the case are we do conclude that the companies in Scenarios 1 and 2 above are worth If we assume that this business, other things being equal, is worth 5x earnings… is $500k a reasonable valuation? Likely not. A more reasonable interpretation is that a portion of his salary is actually a dividend in disguise. Adjusting to a “normalized” salary would increase earnings, thereby result in a more accurate value.
Adjust the salary to a market rate, right? Therein of course lies the problem. What is market rate? To replace the day to day services of the shareholder, is the proper rate $100k? Or 500k? Or 900k? Using our example above, adjusting to $100k in salary would increase valuation by $4.5million. Adjusting to $900k would only increase the valuation by $500k.
These sorts of adjustments can cause significant strife amongst parties.
How to Get Beyond the Strife?
In our experience there are a few options to help parties agree on a replacement cost. One option isto rely on median third party data. Another, is to hire a compensation expert to analyze what it would cost to source a replacement. Ultimately your valuation expert can help guide you make the best decision based on your particular circumstances.
Tip: In Buy-Sell Agreements, consider including language regarding compensation in order to avoid this very conflict down the road.