When forming a business, one of the first things every entrepreneur should think about is their ultimate exit. For most, this is the farthest thing from their mind. As any corporate attorney will tell you, in the same way in which you would plan to protect your children with the creation of a will, your business should also be treated with kid gloves. A Buy-Sell Agreement should be a top priority. Think of it as a prenup for business partners. Read more
Question: What’s the going rate to hire a business owner these days? Or put another way… how much should an owner-operator pay themselves? In some privately held companies that may be a question that is answered by the Board of Directors. But in most privately held companies it’s a question answered by a single person: the one writing the check. Owner compensation is really an arbitrary matter for just about every payroll run… except on the days that someone is trying to value / price a company.
Why’s that? Well, when I pay myself an extra buck where does it come from? Profit. And in most cases what is the basis of establishing value? Profit. See where I’m going with this? We deal with a wide array of valuation engagements in which shareholder compensation becomes a sticking point. Sometimes it’s a bit of gamesmanship (negotiating an M&A buyout), others it’s a highly litigated matter (how does owner comp impact a) valuation and b) alimony in a divorce matter?)
Making matters even more “interesting” – in some instances it is proper to adjust shareholder compensation as part of adjustments to the financial statements, while others an adjustment isn’t proper at all. Given that changes in owner comp will more often than not have a direct – and often material – impact on the calculated value of a company, 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?
Valuation is most frequently a function of earnings. And if that’s the case are we to conclude that the companies in Scenarios 1 and 2 above are worth the same? 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 owner salary is actually a dividend in disguise. Adjusting to a “normalized” salary would increase earnings, thereby result in a more accurate value.
So What’s the Big Deal?
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 $4.5 million. Adjusting to $900k would only increase the valuation by $500k.
These sorts of adjustments can cause significant strife among parties.
When NOT to Adjust?
All shareholders are not created equal. If the shareholder lacks “control” – i.e. the ability to adjust their own salary- it’s unlikely that a change is warranted. For instance, imagine a company in which Suzanne Shareholder is the VP of Sales and owns a 7% stake in the company. She’s paid $1 million per year, which is far above peers in similar roles within the industry. She reports to the CEO (and majority owner) who establishes her salary.
Is a compensation adjustment warranted? Maybe! We’d probably look at the purpose of the valuation to understand whether or not to adjust. If we are valuing JUST her 7% interest- perhaps for a divorce matter – then an adjustment likely wouldn’t be warranted. Why? Because her comp is unlikely to change as a result of the divorce. On the other hand, what if we are valuing the entire enterprise and Suzanne is likely to accept a more reasonable salary in conjunction with the sale? Good chance we’d adjust.
How to Get Beyond the Strife?
We’ve got a couple of moving pieces here: first, understanding whether or not an adjustment to shareholder compensation is warranted. That’s totally in the wheelhouse of us as the valuation expert. Second, we need to understand what to adjust to. Options include:
- Option 1: Rely on third party data. In some industries there is robust data available for purchase.
- Option 2: Rely on your valuation expert. We have a sense for what CEO’s are paid for companies in certain industries and sizes. We can make an educated guess – but we are NOT experts on executive comp.
- Option 3: Hire a compensation expert to analyze what it would cost to source a replacement. There is a material costs to going this route, but in some cases the benefit may be worth it.
Ultimately your valuation expert can help guide you to the best decision based on your particular circumstances.
Tip: In Buy-Sell Agreements / Operating Agreements, consider including language regarding compensation in order to avoid this very conflict down the road.
We often throw around the terms “middle market,” “lower middle market,” and “Main Street.” These are pretty common terms in the finance, banking, and M&A world, but probably less so to most business owners and entrepreneurs. For the sake of clarity we thought we’d dive in.
Defining Main Street vs. Middle Market
It seems that everyone has their own definition, but here is ours. Because of the wide range of company sizes within the definition, the middle market can be further broken down into the following:
- Main Street- <$5 million of revenues
- Lower Middle Market – $5 – $50 million of revenue
- Middle Market – $50 – $500 million of revenue
- Upper Middle Market – $500 – $1 billion of revenue
What Does it Matter?
Company size has an impact on all sorts of considerations in the valuation world. Perhaps the first is the so called “size premium” – the notion that larger companies have higher relative valuations. The reason for this is somewhat straightforward: larger companies are able to better diversify risk and have access to cheaper capital.
Related to the above, business sellers need to consider their target audience when going to market. If you are a Main Street company, chances are that your buyer pool is an individual who is looking to buy a business or maybe a lower middle market company. Chances are exceedingly slim that you are in play for a private equity buyer.
On the other hand, if you are a lower middle market company, your target acquirer is likely in your “bucket” or the next higher. You very well could be in play for a private equity deal… though depending on a range of factors perhaps as an add on rather than a “platform” company. Private equity groups offer healthy multiples and strategic acquisitions, driving up value, compared to an individual buyer looking for a quality investment.
But in the end, what is the main importance? Since business folk are always throwing these terms around it’s always good to get a baseline so we are all speaking the same language.
When a buyer values a target company, the buyer’s valuation is based on the target company’s financial condition on a specific date. In most instances, several months pass between that initial valuation date and the closing date, which is when the buyer acquires the target company. Purchase price adjustments need to be negotiated to reflect changes in the target company’s financial condition between those two dates.
According to the American Bar Association’s 2011 Private Target Mergers & Acquisitions Deal Points Study, 82% of private company acquisitions in 2010 included purchase price adjustments. Read more
So you’ve heard someone throwing around the term “Seller’s Discretionary Earnings” and you find yourself thinking “my earnings aren’t discretionary at all.” Let’s jump in and understand this oft-misunderstood term (which also, confusingly, goes by “Seller’s Discretionary Income,” SDE, and SDI…). Read more
Your small business is ready to grow and you need a loan to make it happen. Just like with a personal loan or a mortgage, you will want to shop around and find the best rate and terms to meet your needs. Being prepared will be key to expediting the process. Follow these four basic steps and watch load offers roll in.
1. Improve your personal and business credit scores.
One of the challenges that we often face is correlating value to “sellability.” In many cases a business may have value to the owner, but there may be a very limited market for the company. (In fact, this notion is the basis of the concept of a Discount for Marketability.) For example, a small 3-person company with a single working owner may generate significant value for the owner. But that same business might not have significant conveyable value to a buyer. Read more
One common step in all business valuations is the “search for adjustments” – whether it be a public company with GAAP accounting or a small pass through entity. Valuation analysts are (almost) always looking at past performance as a proxy for future value. In doing so, we need to understand what the “real” earnings capacity of the company is. Unfortunately, the story isn’t always so clear. Myriad factors cloud the question of “what’s real?” Nonetheless, analysts work through a process to start quantifying these changes – or Adjustments – to earnings to realizing the real number. From there, we can work through modeling performance, risk, and ultimately value.
Why do we care? A few reasons: Read more
Valuation Rules of Thumb are a common way to estimate the value of a business. Their easy to comprehend and seemingly broadly apply. But reader beware: at best, the represent an average. And in real life there’s often no such thing as “average.” Read more
Most business owners perform a business appraisal only once or twice in the tenure of ownership of their company. Oftentimes the reason driving the business appraisal – exit planning, tax considerations, litigation – suggests that the selection of a business appraisal expert is a critical one.
So with limited experience and great importance, how should the business owner select a business appraisal firm? Read more
Quantive is a veteran owned and operated financial services firm. We work exclusively on matters related to corporate value: business valuation, value growth, and M&A advisory.
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