Various factors, such as annual earnings, growth rates, risk, assets, and liabilities, are considered when valuing a business. Owners' compensation is a key assumption; without it, you're not getting the true value of the business.
For example, let's say you're considering two different businesses, one with no earnings whatsoever and one with earnings of $300,000. Assuming comparable assets, liabilities, growth rates, and risk, the business with annual earnings of $300,000 looks like the smarter choice, right? But what about owners' compensation? If the owner with no earnings pays himself an annual salary of $500,000 while the other owner takes a modest salary of $70,000, the first business has the higher value.
However, owners' compensation is not always what it seems, making it important to dig deep to fully understand how, and how much, the they are compensated.
For example, when it comes to compensating themselves, business owners can generally pay themselves as they please. After all, they own the business. However, it's not as simple as looking at the owner's salary and factoring that figure into your business valuation.
Why? Depending on the legal structure of the business, owners may be paid a certain way in order to minimize taxes. For example:
When valuing a business, it's important to determine the reasonableness of owners' compensation. The IRS is aware of tax avoidance schemes and has a long history of challenging owners' compensation issues.
The strategies used in tax court can also be used to determine if owners' compensation is "reasonable."
Moreover, in family-owned businesses, not only should you look at the owner's compensation, but the compensation of family members.
On one extreme, these individuals could have inflated salaries simply because the owner wants to spread the wealth. For instance, an owner might pay an adult child a salary of $150,000 for a basic bookkeeping position that would otherwise pay about $40,000. That extra compensation doesn't reflect the real world and artificially increases the business valuation.
On the other, family members, particularly spouses, often work in the business without pay. A new owner would likely need to pay someone to perform the equivalent work, so a replacement salary for an unpaid family member needs to be factored in.
When it comes to valuing a business, it's crucial to dig deep into owners' compensation so that you can determine an appropriate business valuation.
Finally, consider working with a business appraiser skilled in the art of business valuations.
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