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
Revenues   2,500,000      2,500,000
Earnings      100,000         1,000,000
Salary   1,000,000      100,000
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.