When a business is considering a sale in the near (or even more distant) future, an accurate business valuation is essential.
Without effectively calculating and understanding the valuation of the business, you risk undervaluation of the company and massive loss of negotiation power. When considering a merger, acquisition, or outright sale of a business, it’s key to understand what owner compensation is, why it’s important to get an accurate calculation, and how that calculation will impact the overall business valuation.
When you fully understand and accurately estimate owner compensation and business valuation, you’ll have the confidence to negotiate the best deal available for the sale of your business.
What is owner compensation?
Owner’s compensation refers to the total remuneration that the business owner receives from the company. What ultimately counts as compensation is wide-ranging:
- Annual salary
- Bonuses
- Dividends
- Healthcare
- Travel expenses
- Company vehicle(s)
- Other miscellaneous perks/ write-offs
Basically, any money that goes into an owner’s pocket and any benefits that come solely from being the owner can be considered part of what is known as owner compensation.
The amount and structure of owner compensation varies based on factors such as family-owned status, legal structure, and tax entities. Whether a business is registered as a C-Corporation, S-Corporation, or Sole Proprietorship will determine its tax structure, which will in turn impact owner compensation based on how much of that compensation is subject to certain taxes.
How does owner compensation impact business valuation?
Owner compensation is an impactful component of business valuation because it plays a role in determining a host of other factors, such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), owner replacement salary, and overall net worth and asking price.
In calculating owner compensation, it’s important to ensure that each piece of that compensation package is reasonable and justifiable. Potential buyers will scrutinize each of the business’ financial records, and the owner compensation must be at the perfect “sweet spot” - not excessively high as it could paint a picture of low profitability and not too low (or even, non-existent) as it will negate the opportunity for creating a salary for a replacement upon the sale of the business.
Part of understanding how to calculate owner compensation accurately is looking outside of the business itself in order to compare to industry benchmarks and standards. If there is a significant gap - either way - in the owner compensation within the business in comparison to industry expectations, that may limit the opportunity to set a strategic asking price. Upon the sale of the business, there will likely be a replacement of some or all employees, so that industry standard has to be taken into consideration in your calculations.
Keep in mind that owner compensation records will be requested and examined for several years leading up to the sale - not just the previous year. So, an accurate and reasonable owner compensation is important to consider now - not just when you or your client are looking to sell soon.
Make sure you’re getting it right
- Obtain accurate records: Consult your past financial records and any financial professionals you’ve worked with to make sure your numbers are accurate. These figures include annual salary, all bonuses, insurance, benefits, and company perks. Get all documentation organized and in one place for easy retrieval.
- Research industry standards: Find out the benchmarks in your industry for overall owner compensation and determine what the reasonable and justifiable figures are for companies that are similar in size, legal and tax statuses.
- Use the Owner Compensation Worksheet: Input all of these figures into the simple worksheet we have for just this purpose! This easy-to-use worksheet is a guided, eight-step process designed to ensure correct information is input in order to calculate owner compensation. The goal is to ensure that the owner compensation figures are as accurate as possible with eight focused questions that lead toward a final figure which supports a credible estimate of business value.
With any questions about owner compensation and business valuation, don’t hesitate to reach out to the BizEquity team here.
