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How Shareholder Compensation Affects Value

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.  

A bad buy-sell agreement and an $11million mistake…

Speaking of expensive litigation, a New Jersey case might really drive home that point.  In the Estate of Cohen v. Booth Computers, on appeal the court ruled that a long-ago drafted buy-sell continued to be the controlling document.  It cost the plaintiff $11 million.

In the Cohen case, the buysell provided for a fixed valuation definition: Read more

Critical Valuation Considerations for a Buy-Sell Agreement

In any organization where there is more than one owner, the drafting of a buy-sell agreement is of paramount importance.  Even the strongest business relationships among partners can be tested by retirement, transition or some other form of transaction.

A buy-sell agreement sets the parameters for any potential transaction which may take place. It also provides valuable guidance for those inevitable real life situations. It is absolutely necessary in order to avoid potential litigation upon the departure of an owner, as is often the case the leaving owner believes that his shares are worth more than the remaining owners believe they are worth.

With that in mind, we’ll review a few items that we routinely encounter from a valuation standpoint. Read more

Selling Your Business and Valuation

We recently read a nice article from Charlene Finerty on advice for selling a business. In many regards she was spot on! We have a few more thoughts on from a valuation perspective.

Ms. Finerty astutely points out that while business owners regard their companies like snowflakes (a saying we are sure to borrow in the future), valuators, bankers, and buyers will often aggregate that business into an industry group.  And that’s the point that we’d like to drill down on.

Businesses are indeed unique creatures.  But in order to have a starting point in answering “what’s it worth?” we do indeed start from the industry point of view.  From there we try to answer the question “How is it different?”

Just like in the chart below, there’s a chance that you are exactly like your peer group.  There’s also a pretty good chance that you are above or below the mean.  What we really want to understand is how much you are different than average.

To illustrate, let’s use a say the mean EBITDA multiple in your widget industry is 5.0x.  If your EBIDTA is 5.0, does that mean your valuation is 25x?  It certainly means that the AVERAGE widget manufacturer would be 25x.  But the heart of the matter is understanding how your business deviates from the average, and parsing that into a Fair Market Value.  A certified business appraiser can help you do exactly this.

As a bonus tip: When your valuation expert determines a value- and that value doesn’t mesh with what you need to exit the business – the most important question you should be asking is “why am I different than my peers?”  Figuring that out is the first step in exiting at a better valuation.

 

 

Using a Valuation for a Shareholder Buyout

Shareholder buyouts occur frequently in closely held businesses and often are costly for parties that feel that the payout is unfair – whether too high or too low.

Triggering events for buyouts happen all the time, yet as a business owner they are often not events you spend time thinking about every day. They include:

  • Retirement of a shareholder
  • Shareholder seeking to exit partnership
  • Death of a shareholder
  • Inability to continue working together
  • Shareholder involved in a divorce

They can also be costly if the ownership interests transferred are not valued properly, primarily due to the time and expense associated with litigating shareholder disputes or resolving transactions with the Internal Revenue Service. Even when a buy-sell agreement exists, it may be prudent for the shareholders to engage the services of a trained and accredited valuation professional.

Valuation professionals help mitigate the risks associated with a shareholder buyout by preparing a supportable, well documented valuation report that is based on a well-defined assignment, comprehensive data gathering, and a thorough analysis of the factors affecting the value of the business. The failure to engage a professional to work through valuation leaves the parties involved open to acrimony, drawn out negotiations, and the potential for costly litigation.

Defining the assignment

Confusion and misunderstandings arise in shareholder buyouts when the valuation assignment is not carefully defined between the appraiser and the shareholders for whom the valuation is being prepared.

The most critical aspects of defining the assignment are choosing the appropriate standard of value and properly addressing the impact to value of control and minority interests.

A common standard of value is fair market value, under which a minority interest is valued with the appropriate lack of control and lack of marketability discounts. However, shareholders in a buyout situation may prefer that 100 percent of a company be valued regardless of the ownership interest that will be transferred, since they may be negotiating based on the pro rata value of the entire corporation.

Another standard of value used in shareholder buyouts is fair value, which is commonly used in dissenting shareholder valuations and minority oppression cases. Because fair value is a statutory standard defined by state case law, the business appraiser should further clarify in the engagement letter what discounts will or will not be considered in a valuation under the fair value standard.

Tip: Understanding standards of value is critical, as various discounts for control and marketability can have an enormous impact on the value of the interest appraised.

Gathering the data

Once we have defined the parameters of the assignment the appraiser must gather data, to include both company specific information and industry information. Part of this process normally includes a management interview to both gather data and clarify any of the information provided.

Of concern is access to reliable company data. Depending on the context that the valuation is being performed under, management may have a vested interest in the outcome of the valuation and their answers may be skewed.

A skilled appraiser will determine whether management’s statements makes sense based in context of the company’s within its industry and the market factors that drive the industry.

Analyzing the data

The next step in the appraisal process is for the appraiser to analyze the data gathered and to develop valuation models. An appraiser must ordinarily consider each valuation model or method that is likely to be applicable to the subject company.

Approaches will often include the asset approach involves determining a value indication using the value of the assets of the business less the liabilities. Since the net asset value does not include the intangible value of the company, the asset value will often “set the floor” for any valuation.

The income approach involves ascertaining the value of the future economic benefit stream of the company in today’s dollars. The anticipated benefits are usually based either on historical income statements, adjusted to reflect the ongoing earnings of the business, or forecasted income statements.

Of critical importance is making normalizing adjustments. As small business’ financial statements are often managed to a tax purpose normalizing adjustments are often required to indicate the true economic benefit of ownership. (That being said, minority owners may not always be entitled to such adjustments based on their lack of control. This is a critical point to understand when Defining the Engagement.)

Tip: Normalizing adjustments can have a very large impact on value. Discuss with your valuator if they are appropriate for your situation.

Using the Market Approach, the appraiser will use actual market transactions involving either sales of entire businesses or minority interests. This can provide objective, empirical data for developing value measures that apply to the valuation. This empirical data is critical in valuations for the purpose of shareholder buyouts, because it provides support for values derived under the income approach.

Timing Considerations

Ok, so you get the idea as to how the process works for a shareholder buyout.  But when do you get the valuation?   In our experience shareholders often take a “wait and see” approach, often letting the other party take the lead in pricing discussions.  Negotiating theory tells us that this is a bad move.  But even more importantly, waiting tends to exacerbate the gap between parties – both financially and personally.  More often than not this leads to more strife – which leads to more lawyers, accountants, and valuation folks driving up expense!   With many years working on these matters time and again, we strongly feel that it’s best to be proactive when it comes to getting the valuation completed.

Conclusion

Even if a shareholder does not agree with the opinion of value, the shareholder is less likely to challenge a comprehensive, well documented valuation report by an accredited professional.

When the shareholders involved in a transaction understand and agree with the valuation process, they are more likely to negotiate successful transactions and avoid potentially costly and lengthy litigation.

 

Takeaways:

  • What is the standard of value?
  • Fair Market Value, Fair Value, or something else?
  • What Discounts will be taken? What portion of the business will be valued?
  • Involve your analyst early
  • Insure data discovery is robust
  • Avoid the “wait and see” approach!