By Richard H. Evans

One of the most subjective and discretionary expenses for many small closely held businesses or professional practices is owner compensation. Reasonable compensation is a key assumption in the valuation model as it can have the most impact on the profits of the closely held business. This is due to the fact that compensation recorded in the Company’s books and records and presented in the financial statements is not always at market rates and it is not required to be. For example, owner compensation may have been established for tax planning purposes.

An accepted interpretation of reasonable compensation under the fair market value standard is the salary necessary to hire a non – owner replacement employee of equal experience, education and skill, etc.(1)

Why is Reasonable Compensation Important?

  • If owner compensation is above or below market it can affect the assessment of the subject company’s performance when comparing against industry benchmarks.
  • An understatement of reasonable compensation will lead to an overstatement of enterprise value and enterprise goodwill.
  • An overstatement of reasonable compensation will lead to an understatement of enterprise value and enterprise goodwill.
  • A reasonable compensation analysis can address the concept of personal goodwill. The analysis may show that the owner is being paid above market because he or she is wearing many hats in the company, and is being compensated appropriately. The “above market” compensation translates into the personal goodwill.
  • It can an affect spousal and /or child support.

Things to Remember When Determining Reasonable Compensation:

  • Determine what the owner/manager actually does for the Company.
  • Find an industry benchmark. A good place to start is by looking at the information available regarding the Company’s industry. There are many sources such as Statistics Canada, industry associations; certain fee based and free databases, human resource specialists, etc.
  • Determine how the above industry data is compiled and what their limitations are.
  • Does the owner have control over the business or is he/she a minority shareholder?
  • Look at the factors that the courts have developed to provide guidance on what is reasonable compensation.

                                Richard H. Evans, CPA, CA, CFF, CFE, CVA, ABV, ASA (California)
PresidentRichard H. Evans
McCay Duff Valuations & Consulting

613-236-2360 • 1-800-267-6551

 

 

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