If you’re a business owner, you may choose to pay yourself a salary. ‘Salary’ refers to wages received as a W2 employee of the company. In and of itself, this should never pose a problem when it comes time to selling your business. Martin at Five Star Business Broker of Palm Beach County is constantly surprised how many buyers do not understand that salary paid to an owner (or an owner’s spouse) is very much different than salary paid to anyone else. The owner’s salary is usually characterized as an ‘owner benefit’ simply because it is of direct benefit to the owner. It is not a cost of the business that a buyer would face if he or she were the new owner of the business and were working in the business exactly like the seller did. Hence the owner’s salary is normally characterized as being actual business profits of the business for purposes of selling one’s business. Of course, the business would not be listed or priced as an ‘absentee’ business (which generally get higher valuations), and it hence reasonable to assume that the buyer would be an active owner.
When would an owner’s salary ever not be characterized as being a part of the actual business profits of a business for purposes of selling one’s business? That is more of a tricky question as there are exceptions. Five Star Business of Brokers of Palm Beach County, explains to each party of the transaction the characterization of owner’s salary for purposes of business valuation.
First, an owner may have a highly specialized skill and derive a salary from the business by using this skill. For example, let’s say a very talented designer owns a very large design company that designs and stages high-end special events such as weddings or large corporate functions. It is pretty 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). The proper value judgment here is to expect that the buyer will not be a designer per se (because all sorts of people buy large design businesses), and specifically will not have the same same skill-sets as the seller-designer. It is a matter of common sense judgment to suppose that the buyer can not be ‘expected’ to replace the seller-designer. Thus, the cost of hiring someone to replace the seller-designer must be reduced from the owner benefit. It is not, however, proper to simply deduct the actual owner’s salary. The proper cost is to simply deduct the replacement cost of the owner. In many cases (such as a plumbing or electric company), the salary of a working owner who works in specific trade is still properly characterized as owner benefit because the seller knows that the only realistic buyer is someone already working in that specific trade.
Second, Five Star Business Brokers of Palm Beach County finds that there are many situations where an owner and their spouse both are paid salaries and both are actually working in the business. In that situation, it may not be appropriate to characterize both salaries as owner benefit. Buyers would not be expected to work ‘two’ jobs. The seller should know that a buyer for his or her business may not have a spouse who is willing or able to perform the duties of the seller’s spouse. Doing so would not be a reasonable expectation. In such a situation, we again must deduct the replacement cost (not necessarily the actual salary) from owner benefit of the selling spouse that a buyer is less likely to replace. At times though, this general rule may find an exception or two. 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, a seller would reasonably expect that another ‘husband and wife’ team would be the only logical buyer of the restaurant. Small ‘mom and pop’ restaurants frequently are set up in such a manner, and people in the industry know that.
Ultimately, a buyer may use any business valuation method he or she so desires. After all, this is a free country! As such, a buyer may not want to replace the owner (or two owners if it’s the aforementioned husband-wife team) and may want to be absentee or partially absentee. 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). It is most important at Five Star Business Brokers of Palm Beach County that both parties are clearly explained how and why the valuation method assumed a non-absentee working owner, and whether (and why) that working owner’s salary is characterized as owner benefit.
Give Martin at Five Star Business Brokers of Palm Beach County a call today with questions about valuing your business when it comes to the interpretation of an owner’s salary.
Located in Palm Beach County, Florida, Five Star Business Brokers proudly transacts business sales throughout the areas of West Palm Beach, Lake Worth, Palm Beach Gardens, Boca Raton, Jupiter, Delray Beach, Boynton Beach, Wellington, Palm Beach, Royal Palm Beach, and Riviera Beach.