Owner’s Salary Affects Valuation
Many business owners choose to pay themselves (or their spouses) a salary. An owner’s salary or compensation may refer to wages received as a W2 employee or payments received as an independent contractor or to some other entity controlled by the owner. This is entirely legal and ethical and in theory should never pose a problem when it comes time to valuing and selling a business. It does alter the reported Seller’s Discretionary Earnings when included as a part of the owner benefit, particularly since many business owners pay themselves arbitrarily with no relation to their actual market value. Some buyers are confused that salaries or compensation paid to an owner (or an owner’s spouse) generally benefits the owner in the same manner of reportable profits. It is crucial that buyers of business are educated by the business broker as to how and why an owner’s salary is generally considered to be a part of the total profits or ‘adjusted owner benefit’ of a business.
Owner’s Salary an Owner Benefit
The owner’s salary is usually characterized as an ‘owner benefit’ because it is of direct economic benefit to the owner. The owner’s salary is not a cost that the buyer would face after purchasing the business. Rather, it is of direct economic benefit to the seller and would remain so for the buyer. Hence the owner’s salary is normally characterized as being part of the adjusted owner benefit or cash flow of the business. The key to making this assumption is whether the buyer may be reasonably expected to also work in the business and replace the seller’s role in the business after the sale. The more highly skilled and unique a role the seller plays in the business, then the more difficult it will be for the buyer to replace the seller. Each business must be viewed individually, but owner salaries are typically included as owner benefit.
Exceptions to the Rule
When would an owner’s salary ever not be characterized as being a part of the actual business profits?
- Some business owners possess a highly specialized skill and derive a salary from the business by using this skill.
- For example, let’s say a very talented designer wishes to sell her large special event-related company.
- The seller-designer works in the business and has almost irreplaceable talents and skills that drives much of the company’s sales and profits.
- Here, the owner would need to be replaced by a highly trained and experienced designer after the sale in order to maintain the same level of profits or owner benefit.
- It is unlikely to expect that only a designer with the same set of skills as the seller would buy such a business (in which case the buyer-designer could simply replace the seller’s role with himself or herself).
- It is a matter of common sense judgment to suppose that the buyer can not be expected to replace the seller-designer.
- Thus, the replacement cost of hiring someone else as a designer must be accounted for when calculating the owner benefit.
- In many industries (such as small plumbing or electric companies), the salary of a working owner who has specific skill sets is still properly characterized as owner benefit.
- This is because the only realistic buyer of such a business has the specific skill sets of that specific trade.
- The business must be priced conservatively in order to account for a working owner, but the working owner’s salary in such instances is still a part of the owner benefit.
Owners are Husband-Wife
There are many situations where an owner and their spouse both are paid salaries while both actively work in the business. In that situation, it may not be appropriate to characterize both salaries as a part of owner benefit. Buyers would not be expected to work ‘two’ jobs. It is not reasonable to expect that a buyer replace two working owners. In such a situation, the spouse’s salary is not a part of the owner benefit. Instead, the spouse’s salary is counted as a regular business expense. If the spouse is overpaid relative to their replacement cost, then the difference (or overpayment) is a part of the owner benefit.
Small Restaurants
Let’s say a husband and wife own a small restaurant. Let’s further say that the husband supervises the kitchen and the wife is the unofficial ‘hostess’ who makes small talk with the customers and generally keeps an eye on things. Here, it is reasonable to expect that another ‘husband and wife’ team would be the only logical buyer of the restaurant. Importantly, the husband and wife of operating a small restaurant have no unique skills or licenses that would be difficult for a buyer to obtain. Small ‘mom and pop’ restaurants frequently are set up in such a manner with two working spouses, and their salaries are both considered part of the owner benefit.
Buyers Use Own Valuation
Ultimately, a buyer may use any business valuation method he or she so desires. After all, let’s remember that each party to the deal is ultimately in charge! A buyer may not want to replace the owner (or two owners if it’s a husband-wife team), and instead prefer to be an absentee owner. The buyer’s valuation of the business will thus go down because the buyer would have to face replacement costs for the working owner(s). Nevertheless, the seller may choose to wait for an acceptable valuation from a buyer who will choose to maintain a higher Return on Investment by working in the business.
Give Martin at Five Star Business Brokers of Palm Beach County a call today with questions about valuing your business in regards to the interpretation of an owner’s salary.