Interpreting An Owner’s Salary

Owner’s Salary Affects the Purchase Price of Businesses

Many business owners choose to pay themselves (or their spouses) 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. Still, 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. 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’ by which the business is valued.

Owner’s Salary Is Usually An Owner Benefit When Valuing Your Business

The owner’s salary is usually characterized as an ‘owner benefit’ simply because it is of direct economic benefit to the owner. The owner’s salary is not a cost that the buyer (after purchasing the business) would face if he or she were working in the business in a similar way as the seller. 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 actual business profits (or adjusted owner benefit).

When The Owner’s Salary Is Not Considered An Owner Benefit 

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?

  • 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 company has many other valuable assets such as equipment and a large support staff, but the owner would need to be replaced by a highly trained and experienced designer after the sale.
  • 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 to replace the seller-designer must be accounted for when calculating the owner’s salary and 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 and should be included in the valuation.

When Both Spouses Are Working Owners The Business Valuation May Differ

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. The seller should know that a buyer 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.

Must Deduct Replacement Cost of One Spouse When Calculating Business Valuation

In such a situation, the spouse’s salary is not a part of the owner benefit when determining the valuation of the business. Instead, the spouse’s salary is simply 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.

An Exception to the Rule When Selling 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, 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.

Buyer Ultimately Uses Their Own Valuation When Buying A Business

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 the aforementioned 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).

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.