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Determining “reasonable compensation” in business valuations

Posted by Mary Ellen Biery
Determining “reasonable compensation” in business valuations

Beauty is in the eye of the beholder, as the saying goes, and so apparently is “reasonable compensation” for a business owner.

Many variables can make providing a defensible, rational estimate of reasonable compensation extremely challenging when a valuation analyst is conducting a business valuation, according to Kevin Yeanoplos, CPA/ABV/CFF, ASA, Director of Valuation Services at Brueggeman and Johnson Yeanoplos, P.C. That is because owners of private companies have discretion in terms of the size, timing and payment methods used for compensation and profit distribution, so each owner might handle compensation differently.

However, most valuation analysts would agree that normalizing financials to reflect reasonable compensation for the business owner is critical to avoiding distortion of a business valuation. “There may not be a single adjustment that is more important than the adjustment for reasonable compensation,” Yeanoplos says. “It can make millions of dollars difference [to the business value], depending on that adjustment.”

A really important estimate

Using a number for reasonable compensation that results in a valuation that is too high or too low can cause issues when it comes to alimony payments, gift and estate taxes, regulations, etc., according to Yeanoplos. “I’ve got to know what reasonable replacement compensation is to be able to determine the true profit” of the business being valued, he says.

Yeanoplos will discuss reasonable compensation methodology, elements of compensation, market pricing considerations and common mistakes in determining reasonable compensation during a Sageworks webinar on Sept. 28 ("Keys to the Never-Ending Search for Reasonable Valuation Compensation"). He will also review third-party sources for estimating business owner compensation.

Valuation analysts have to be careful not only about the survey data they use to help determine reasonable compensation, but also about adjustments made for productivity, duties and commingled profits, Yeanoplos says. For example, owners will sometimes misclassify personal expenses as valid business expenses, and valuation analysts must be looking for those as they review financials. 

Below are eight examples of misclassified personal expenses to watch out for, according to Yeanoplos:

1. Rent in excess of market prices paid to a related party

2. Overpaid family member employees

3. Phantom “employees” who are family members

4. Personal usage of company vehicles or other company assets

5. Golf, yacht and social club dues and usage costs, including lessons

6. Loans at below-market interest rates

7. Legal and other professional fees paid for personal matters, such as a divorce

8. Non-business costs of cell phones and internet usage

“If there’s a personal expense that’s been misclassified as a valid business expense, what that does is understates the profit,” Yeanoplos says. “There needs to be an adjustment to increase the profit.”

“All of these things work together,” he says.

Learn more during the webinar, "Keys to the Never-Ending Search for Reasonable Valuation Compensation."

Additional Resources

Practice Aid: Common Errors Found in Valuation Reports

Webinar: The Bermuda Triangle of Valuation: Bias, Uncertainty and Complexity

Sageworks Valuation Solution

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