When a professional appraiser values a business, he or she will likely seek input from the current owners of the business to get the inside scoop on how the business works. In fact, “nature of the business and history of the enterprise since its inception” is one of the eight factors to consider under IRS Revenue Ruling 59-60, which provides guidance on how to value private business interests for gift and estate tax purposes.
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Case in Point When determining the fair market value of a business, compensation paid to the owners and executives should be at a level that today’s market would pay for an employee – executive with no substantial ownership interest. To illustrate, John Menard, Jr. founded and owned 100 percent of the voting shares and 56 percent of the nonvoting shares of Menards. The company operates a chain of retail stores throughout the Midwest that sells hardware, building supplies and related products. Mr. Menard had received a $17.5 million bonus in 1998 (in addition to his regular salary) that the IRS and Tax Court had considered to be excessive. In 2009, the Seventh Circuit Court of Appeals reversed a Tax Court decision saying that Mr. Menard’s compensation was indeed excessive. Compare his bonus to the total compensation paid to Home Depot’s CEO ($2.8 million) and Lowe’s CEO ($6.1 million) in 1998. Both of these comparable companies are much larger than Menards. So if you were valuing Menards, would you assume that the CEO’s replacement compensation should have been $17.5 million plus a regular salary? It’s unlikely, because the salaries paid to other hardware retail chain CEOs provide unbiased real world evidence of what the Menards’ CEO should have been paid. |
The AICPA Statement on Standards for Valuation Services states, “Performing a valuation engagement with professional competence involves special knowledge and skill.” But it isn’t only knowledge related to valuation principles that’s required. Appraisers also need a comprehensive understanding of the business itself and what drives its value. Who better to provide that input and knowledge than the people who own and operate the business?
Stick to the Facts
Like any information that an appraiser uses to value a business, interviews with company insiders need to focus on the facts, not the individuals’ opinions and personal expectations. That’s often difficult for an owner to do, especially if he or she has invested blood, sweat and tears to grow the business.
For example, a key element of business appraisal is whether or not compensation paid to the owners and executives seems reasonable based on comparable salaries paid to equally qualified people for performing similar tasks at comparable companies. The correct answer requires the owner to evaluate salaries from the perspective of an unbiased third party. How would a hypothetical investor perceive the current level of owners’ compensation? Executive compensation studies can provide reality checks for owners who are unfamiliar with today’s compensation market.
A Closer Look at Owners’ Compensation
Many business owners have worked so long for themselves that they lose touch with modern compensation levels. Some overestimate their contributions to the business and write themselves paychecks whenever they need cash. Others underestimate what their contributions would be worth if they worked as an unrelated employee elsewhere.
Downplaying salary expense is common among S corporations and other pass-through entities that can take distributions tax-free to the extent that the owners have adequate tax basis in the stock. S corp owners may attempt to minimize owners’ compensation expense to avoid paying payroll taxes.
The reverse is true for C corporations. They may overstate owners’ compensation to avoid paying double taxes — once at the business level and again at the personal level — on corporate dividends.
From a valuation perspective, owners’ compensation matters, because it’s a large expense that can have a significant impact on value. Taking extra cash away from a business in the form of excessive owners’ compensation depletes its value. Conversely, underpaying executives frees up the company’s working capital and diminishes its need for debt, which, in turn, gives the company an opportunity to add value.
Other Subjective Elements
Reasonable replacement compensation is just one example of operating issues that owners may lack objectivity about. Owners also tend to overestimate how integral they are to the business’s success and customer relationships, arguing for substantial key person discounts. These discounts are warranted in rare instances when a large number of customers wouldn’t transition to a new owner, when the company has little or no succession plan in place, or when the owner possesses unique skills and experience that would be difficult for a replacement to replicate.
During the appraisal process, some owners are surprised to discover that some customers, while not tied to the owner personally, might be tied to one or more employees. Companies without valid noncompetition agreements with key employees might be worth less than the owners think.
Garbage In, Garbage Out
Business owners can help valuators root out subjective areas, whether they increase or decrease the value of the business. Even though owners have intimate knowledge of the business and its strategic plans, owners need to look at the company through the eyes of an investor. If owners are unable to think like rational, objective investors, the appraiser’s conclusion may be skewed.