Normalizing Owner Compensation in Business Valuations

Normalizing Owner Compensation in Business Valuations SESSION DESCRIPTION Business valuators know that normalizing owner compensation is a common and important step in understanding the value of a business, and it must be addressed tactfully. This presentation will address the commonly-accepted methodologies for normalizing owner compensation and include tips and recommendations to improve efficiency, help avoid costly errors and improve disclosure. This session should be of value to anyone who prepares or uses business valuations. LEARNING OBJECTIVES After completing the session, participants will be able to Describe the accepted methodologies for normalizing owner compensation Explain what detailed information they need, and how to obtain it Determine which sources of comparability data are most reliable Improve documentation of key points in the valuation report Explain how they came to their conclusions on normalized compensation PRESENTER BIO Stephen Kirkland is a compensation consultant for business owners. He issues opinion letters and helps determine normalized compensation amounts for business valuations. He has testified as an expert witness in four U.S. Tax Court cases to opine on reasonable compensation amounts for business owners. He has been engaged in this capacity by attorneys across the country including law firms representing corporations, IRS attorneys and US Department of Justice attorneys. FIELDS OF STUDY 1 Hour Management Advisory Services (MAS), 1 Hour of Specialized Knowledge & Applications (SK&A) 2015 National Association of Certified Valuators and Analysts (NACVA) 1

Normalizing Owner Compensation in Business Valuations By Stephen Kirkland Normalizing adjustments are often the most hotly-debated component of business valuations. Owners compensation may produce large, subjective adjustments and must be handled carefully. The adjustments can dramatically impact the conclusion of value, especially when the company s value is determined in large part by using a multiple of earnings. If the value is determined to be eight times earnings, for example, adjusting owner compensation by one dollar has an eight-dollar impact on value. To illustrate this impact, assume that a company s value is considered to be eight times EBITDA. The chart below shows how a $200,000 downward net adjustment in the owner s compensation could increase the conclusion of value by $1,600,000: Before Adjustment After Adjustment EBITDA $1,000,000 $1,000,000 Decrease in owner pay 200,000 EBITDA after adjustment 1,000,000 1,200,000 Multiple x 8 x 8 Conclusion of Value $8,000,000 $9,600,000 Owner compensation amounts are controversial, especially when hard-working business owners are questioned about their own pay. (Unfortunately, some people view their compensation as a measure of their worth as a human being.) Determining appropriate compensation amounts is also a complex process, so these adjustments must be handled carefully. Why Normalize Compensation? Normalizing a business financial position and results of operations as reported in the financial statements or income tax returns helps to analyze its actual financial position. So when normalizing owner compensation, the purpose is not to restate the financial statements, but to help us understand the company s operations. Then we can better estimate what amount a buyer would be willing to pay. The majority owner of a business usually has considerable opportunity to set his or her pay at whatever level he or she chooses. However, the owner of a minority interest may not be able to influence compensation amounts, so it may not be necessary to normalize owner compensation when addressing the value of a minority interest. 2015 National Association of Certified Valuators and Analysts (NACVA) 2

Owners of controlling interests set their own pay at above-market or below-market levels for many reasons: Shareholders of C corporations may raise their compensation, and eliminate dividends, to avoid two levels of income tax (corporate and then personal). S corporations may pay their shareholders below-market amounts to minimize payroll taxes. There may have been deferred compensation that was paid years after it was earned. Catchup pay is especially common when start-ups cannot pay the founders the full value of their services because of limited cash flow. Yet these early years may be when the owners work the hardest. The owners may shift some of their pay to family members who are in lower tax brackets. When dealing with closely-held or family-owned businesses, always ask for all related parties to be identified. Remember to ask about the owner s spouse and extended family members (i.e. the grandson who is thousands of miles away at college and is getting paychecks approximately equal to his college costs). Identify all those who have been receiving paychecks but would not have been paid, or would not have been paid as much, if the company had been owned by another party. This may include a former shareholder or the owner s paramour. Owners can take some of their pay in different forms, such as rent or loans, for tax avoidance. Owners might play with pay because of issues related to bankruptcy, marital dissolution, ego (i.e. my W-2 must be seven figures! ), social security benefits (i.e. a spouse may need credits), financial aid or mortgage refinancing. My favorite reason for an owner being overpaid or underpaid is: We ve always paid that amount. Tip: Ask early in the process for all related parties to be identified, especially if you have not worked with the company before. Remember that you may need to normalize pay for some family members who are not on the payroll, such as the owner s spouse who provides referrals and other valuable services from time to time. Standards of Value Just as no one valuation method is right for every situation, there is no one-size-fits-all method of normalizing compensation. To determine the right approach, we must understand the purpose of the business valuation and whether we are focusing on fair market value, investment value or fair value. For example, in a merger or acquisition, we may be interested in investment value. When considering the investment value of a controlling interest, where the target will get tucked into the acquirer, replacement reasonable compensation could be zero or close to it. This type of cost savings may be a driving force for the merger or acquisition. 2015 National Association of Certified Valuators and Analysts (NACVA) 3

Under a value to the holder standard, there may be synergistic benefits to other entities owned by the holder which need to be considered and quantified. If the valuation is for estate planning purposes, we may be looking at fair market value. Consider This: What Would Your Own Replacement Compensation Be? What do you tell your clients about the fees for your services? What would be your replacement compensation, if you had to be replaced next month? Are you paid for what you do, for what you know, or for who knows you? Consider writing a 750 to 1000-word summary of what your services are worth to your organization. Explain the bases for your opinion. Opinion of another Professional Has an independent compensation consultant already been engaged to opine on the compensation amount or plan? There may have been input from an attorney, CPA or other professionals, but you need to satisfy yourself, and follow professional standards if you rely on the work/opinion of another professional. Gathering the Facts Since normalizing adjustments should reflect the reasonable compensation of replacement executives, the first step is to understand the relevant facts about the owner that will help determine what a replacement would earn. Remember that owners may have decision-making responsibilities in all areas: personnel, marketing and sales, procurement, financing, price setting, quality control, union relations, customer relations, and they may help oversee legal issues. You might have to prod them, so ask about each of these areas. Consider how you would respond to similar questions - you may simply say that you prepare business valuations, even though you are also deeply involved with your firm s business development, training, quality control and administration. Interview the owners and see what they reveal about themselves. Ask both specific and general questions about each owner s duties, accomplishments and compensation. Be sure to inquire about: Work efforts, specific responsibilities, travel requirements and challenges. Their most significant achievements during recent years, including favorable contracts negotiated, key customers or employees attracted to the company and any successful reorganization of the company. Whether compensation amounts were for current or past services. Relationships they have with customers, prospective customers, regulators, referral sources, suppliers, lenders and employees. 2015 National Association of Certified Valuators and Analysts (NACVA) 4

Any awards or acknowledgements they have received from suppliers, customers or industry associations. Any employment contracts, non-compete agreements, buy-sells or other agreements between the individuals and the company. 1 Details of corporate debts and leases guaranteed by the owners, including interest rate differentials between guaranteed versus un-guaranteed loans. The company s organizational chart. The company s compensation philosophy. One of the most important issues to understand is: how were the historical compensation amounts determined? Tip: Ask yourself whether the formula or methodology used to compute past pay amounts appears to be reasonable, looking at the big picture. Unreasonable formulas produce unreasonable amounts. Ask for a resume or bio for each of the owners and their family members. Also ask about unusual skills and traits. For example, being a celebrity is valuable in many businesses. One technology company was able to raise $1 billion of capital on Wall Street primarily because of the founder s name recognition and reputation. Another celebrity s name attracted valuable publicity and thousands of customers to an amusement park. Also, being technologically savvy or multi-lingual is increasingly valuable for owners in some industries. Ask how the owners spend their time. The owner of a construction company in the Midwest told me that he spends most of his time on business development. He chases the next project. Yet the owner of a similar construction company on the east coast told me he spends most of his time on quality assurance. He visits job sites, inspects materials, talks to workers, and he personally walks the roof of every completed building. Be wary of those who are moving toward retirement and shifting some of their duties to others, but who don t readily admit to doing so. Ask some open-ended questions such as, What else do I need to know in order to normalize your compensation? Provide your questions in writing and ask that their responses be in writing. There are two advantages to having this in writing. First, you will have documentation for your files. Second, most people think things through more carefully when they respond in writing than when they answer verbally. Tip: It is a good idea to get these responses before your final face-to-face meeting with the client so you can ask for clarification at that time, if you need to. 1 In some states, LLC members may be prohibited by law from competing with their own LLC. 2015 National Association of Certified Valuators and Analysts (NACVA) 5

Data on Tax Returns One good source of information is the company s past income tax returns. However, with all due respect to tax return preparers, we must use data from returns with caution. In the haste of their busy seasons, preparers may tend to focus on the items that impact tax liability and let other disclosure-type items simply roll forward from one year to the next in their software. Although most tax return preparers do a good job, they work under considerable time pressure. So don t blindly rely on an officer s Percent of time devoted to business as it is shown on IRS Form 1125-E. Also, be careful about the Amount of compensation 2 shown on that form since there may have been compensatory amounts recorded as loans, rent or other types of expenses. It is always interesting to ask what the owner put as Occupation next to his or her signature on page two of Form 1040. Remember that they signed the tax returns under penalties of perjury. Don t assume that the business activity code shown on your client s federal income tax return is correct. Confirm that code early in the process because the return preparer may simply have used the code that was already in the software and rolled forward. A business may have changed dramatically since the tax preparer last looked up that code. Also, when someone tells you how many hours they worked, it would be worth knowing whether they treated their partnership or S corporation interest as a passive activity on their personal income tax returns. 3 Not to be distrusting, but if you are later deposed, you will want to know in advance whether the owner told you the same story he or she told the tax return preparer. The Factors In one important case, the Ninth Circuit Court of Appeals examined five categories of factors: The employee s role in the company (i.e. position, hours, duties), external comparison (amounts paid by similar companies for similar services), the character and condition of the company (i.e. size, net income, capital, complexity), conflicts of interest (any relationship between the company and the employee which might permit them to adjust pay), and internal consistency (i.e. is there a structured, formal, consistently-applied compensation plan which is fair, and reasonable and was it followed?). 4 Some key factors to consider include: (1) the employee's qualifications; 2 Instructions to Form 1125-E say to include total deductible compensation (such as salaries, commissions, bonuses, taxable fringe benefits, etc.) 3 Internal Revenue Code section 469 4 Elliotts, Inc. v. Commissioner, 716 F.2d 1241 2015 National Association of Certified Valuators and Analysts (NACVA) 6

(2) the nature, extent, and scope of the employee's work; (3) the size and complexities of the employer's business; (4) a comparison of salaries paid with the employer's gross revenue and net income; (5) the prevailing general economic conditions; (6) a comparison of salaries with distributions to shareholders and retained earnings; (7) rates of compensation for comparable positions in comparable companies; (8) the salary policy of the employer as to all employees; (9) the amount of compensation paid to the particular employee in previous years; (10) the employer's financial condition; (11) whether the employer and the employee dealt at arm's length; (12) whether the employee guaranteed the employer's debts or leases; (13) whether the employer offered a pension plan or profit-sharing plan to its employees; and (14) whether the employee was reimbursed by the employer for business expenses that the employee paid personally. Comparability Data An important step is to look for comparability data, which is a collection of actual amounts paid by similar companies for similar services. This is a form of benchmarking. The theory is that the market establishes fair compensation, which is what it would take to replacement someone. Although comparability data is often used to normalize compensation, getting good, reliable data may not be easy. When I receive a call about new a project, the caller often says that the business he or she is calling about is somewhat unique. This immediately raises a question in my mind: will comparability data be available? Yet the caller always expects me to find lots of comparability data. 5 One perfect comparable, such as a duplicate of your client, may not exist. Even if a perfect match did exist, how could you get reliable information from that other company? You could send a questionnaire to that company, but you would be asking for some extremely sensitive information that few employees have access to, so you may not get a response at all. If you did get a response, you may not really know who completed the questionnaire or how complete and reliable that information was. 5 Even though a company may be unique, the qualifications, duties and accomplishments of the person running the company may not be unique. So a search for comparability data may focus more on the individual than on the company. 2015 National Association of Certified Valuators and Analysts (NACVA) 7

Therefore, we use compensation databases and published surveys. There are many of them available from industry associations, government agencies and publishing companies. Make the effort to find the best data available. In selecting sources for comparability data, remember that the courts are strict when determining what is really comparable. So once you have selected a survey or database, be prepared to answer some tough questions about it: Where do they get their information? How extensive is their data? How do they deal with duplication? How do they handle outliers? How many of their incumbents are in bankruptcy? How many are S corporations? How many of the companies are growing? 6 Comparability data will typically include some individuals who have been over-compensated and some who have been under-compensated. In other words, these are raw amounts that have not been normalized. Yet by compiling a large number of samples, and then eliminating outliers, we can determine averages, medians, trends and ranges of market levels of pay. The reliability of the data increases as the sample size increases. Consider using more than one source. Then, if someone challenges your data, they will have to challenge multiple sources. But also be careful when using different databases for different clients, because doing so can give the appearance of cherry-picking. Tip: It is usually acceptable to include compensation amounts paid by non-profits and publicly-traded companies, if the facts are otherwise comparable. 1. Publicly-Traded Companies Publicly-traded companies file financial information with the United States Securities and Exchange Commission (SEC.gov). The SEC then publishes some of that information, including total compensation amounts for each company s top officers, on its EDGAR 7 database. Compensation amounts available through EDGAR can be helpful as comparables although publicly-traded companies tend to be much larger, more diversified and have more layers of management than our clients. 2. Almanac of Business and Industrial Financial Ratios CCH publishes the annual Almanac of Business and Industrial Financial Ratios which is often used for benchmarking. The data is obtained from actual income tax returns filed with the Internal Revenue Service. CCH sorts the data to provide approximately fifty performance indicators on about 200 industries. The data is broken down by size categories based on total assets. It shows, as a percent of gross revenue, the average 6 Remembering the answers to specific questions such as these can be difficult. Consider including the answers in footnotes or an exhibit to your report if you expect to have a copy of the report in front of you when being cross examined months later. 7 Electronic Data Gathering, Analysis and Retrieval 2015 National Association of Certified Valuators and Analysts (NACVA) 8

amount spent on certain categories by companies within each size range. For example, it may show that companies using a certain NAICS code, and having total assets between $1 million and $5 million, spent an average of 4% of their gross revenue on officers compensation in 2014. But it does not say how many officers each of these companies had or where they were located. Also, CCH includes data from income tax returns filed by partnerships and sole proprietors. However, the tax return forms for those entities do not include separate line items where officer compensation expense can be separately disclosed. Therefore, the amount of officer/owner compensation expense the Almanac includes for each of these entities would be $0.00, causing distortion of the overall average. Still, these ratios may be helpful in comparing your client s total officer compensation expense to industry peers. 3. Annual Statement Studies Financial Ratio Benchmarks The Risk Management Association (RMA) compiles and publishes Annual Statement Studies Financial Ratio Benchmarks, which is another popular source of benchmarking data. The members of RMA, which are banks, credit unions and other lending institutions, submit financial data obtained from their customers credit applications. The data is organized by time period, industry (using NAICS codes) and company size. The print version is not organized by geographic area but the online version has data broken down among six regions: (www.rmahq.org/tools-publications/tools/estatementstudies). Annual Statement Studies shows certain amounts as a percent of gross revenue, including % Officers, Directors, Owners Comp. However, it does not show how much compensation the companies included in other categories, such as Cost of Goods Sold. Also, RMA includes drawings of partners and proprietors in the officers compensation, even though the amounts of those drawings may not bear any relationship to what officers compensation expense would have been in a corporate environment. Annual Statement Studies shows the median percentage of gross revenue used to pay officers. (The median may be a better guide than the mean since the median is less influenced by each extreme amount.) But do we always want to use the median as replacement cost for a certain officer? Perhaps we should use the median only when normalizing pay for a middle-of-the-pack performer. RMA also shows how much officers were paid at the cut-off for the upper and lower quartiles. 4. U.S. Department of Labor The Department of Labor s Bureau of Labor Statistics gathers and publishes basic wage data on its website: www.bls.gov/ncs. The data is available by state. The Occupational Employment Statistics (OES) program produces employment and wage estimates annually for over 800 occupations. These estimates are available for the 2015 National Association of Certified Valuators and Analysts (NACVA) 9

nation as a whole, for individual states, and for metropolitan and nonmetropolitan areas; national occupational estimates for specific industries are also available at www.bls.gov/oes. Also, the Department of Labor s Employment and Training Administration sponsors America s Career InfoNet at www.acinet.org. This website offers free salary information by zip code or state for 800+ occupations. 5. Internal In some businesses, comparability data may be available internally. Internal data includes evidence that the business paid an unrelated non-owner a similar amount for providing similar services. Comparability data may also include compensation amounts paid to the same individual in an earlier year. The theory is: if her services were worth $x in earlier years at a previous employer, then they must be worth $x now. Prior pay can be especially helpful if it came from a company that the subject employee did not control at the time. In other words, it is more telling if the prior pay came from a third party and not from a company where the subject had the ability to set his or her own pay level. But even then, it is usually not that simple. 8 6. Compensation Surveys Using multiple sources (of comparability data and financial ratios) also provides the opportunity to confirm a conclusion. At times, one source may conflict with another and it becomes necessary to determine which is better under the circumstances. The more reliable one is usually the one that has the most data (drawn from the largest sample) and enables you to focus most narrowly on comparable companies and comparable positions. So whatever sources you use, try to include data that matches your client in terms of the four key data points (discussed later): titles and duties performed by the owner, industry, geographic location and company size or years of experience. Also, draw data from the relevant time period or adjust the amounts for changes in pay levels over time. 8 The Tax Court has examined the issue of prior pay in several cases, including Choate Construction Company v. Commissioner, T.C. Memo. 1997-495. 2015 National Association of Certified Valuators and Analysts (NACVA) 10

Some sources of compensation comparability data: ERI Economic Research Institute s Executive Assessor and Salary Assessor 9 erieri.com and salaryexpert.com KeneXa (bought by IBM). CompAnalyst offers various modules. http://www-03.ibm.com/software/products/en/ibm-kenexa-companalyst-enterprise-on-cloud Business Valuation Resources, LLC bvresources.com Executive Compensation in Small (< $10 million) Private Companies $495.00 CEO & Senior Executive Compensation Report for Private Companies 2013-14 $1,995.00 Trade Associations can be expensive but your client may get discount if a member. RCReports.com $199 per report, or annual subscriptions at $549 (basic) or $1,049 (premium). ReasonableCompensation.com $85 each MarketPay.com does not provide comparability data. LOMA.org Compensation surveys about $3,360 per executive. CompDataSurveys.com Reports by industry and region pricing options around $1200. PayScale.com Gathers data from job searchers. Salary.com BLR-Business and Legal Resources compensation.blr.com Equilar, Inc. equilar.com GuideStar.org (data from non-profits) Some free, some for a fee the focus is on non-profits with over $10 M in revenue. PAS, Inc. (construction contractors) will customize reports and surveys (pas1.com). MicroBilt.com/industry-statistical-data.aspx 9 I primarily use ERI Economic Research Institute s compensation assessors. I spent a day with their analysts and reviewed their quality control procedures. ERI seems to have the most extensive compensation data available, since they purchase hundreds of salary surveys, and they allow subscribers to sort that data by the four key data points discussed in this article (titles and duties, industry, geographic location, and company size or years of experience) and ERI adjusts for timing differences. 2015 National Association of Certified Valuators and Analysts (NACVA) 11

Remember: Some surveys and databases provide good explanations of the methodologies they use for data-collecting and quality control. Consider printing those explanations and attaching them as exhibits to your reports. The four key data points: I. Titles and Duties - Don t be misled by titles. As mentioned earlier, business owners in the same industry can do very different things. Because some owners perform multiple duties, you may need to run comparables for multiple titles and blend them. Since it is common for owners to wear multiple hats, we need to give them credit for all they do, but be careful when stacking. What I mean by that is we do not usually determine a compensation level for a CEO and then determine a separate amount for a full-time COO, and then add those two amounts together. One person typically does not do everything that two separate senior executives would normally do if they were each carrying a full load. So where one person has multiple titles, you may find it appropriate to determine pay for the higher position and then increase it by some reasonable allowance. The most common approach may be to determine a range of pay for the top position, and they move upward in the range to accommodate for the multiple positions. For example, the subject s pay may need to be at the 80 th percentile or 90 th percentile rather than at the median. If the range data is not available, another approach would be to increase the higher amount by some percentage, perhaps 10% or 25%, to give credit for the additional duties. Yet some workaholics deserve much more than an extra 25% because it would take more than one person to replace them. Also, remember that in family-owned businesses, it is common to give glamorous titles to family members who do not play key roles in the business. The thinking is that someone who is going to receive little or no compensation may be satisfied with a big title instead. At first glance, this seems like a harmless practice. However, be careful when using those titles to obtain comparability data. II. III. Industry - Businesses are typically categorized by NAICS code. 10 Some companies have multiple business lines and use more than one code, so blending may be necessary. For example, a company may be in manufacturing and wholesaling. Geographic Area - Ideally, we prefer to find data from companies located near our clients since compensation amounts can vary from one region to another. If necessary, you can use data from other areas and adjust it for pay scale differences. 10 Most data collectors use the six-digit North American Industry Classification System (NAICS) although the U.S. Securities and Exchange Commission still uses the four-digit Standard Industrial Classification (SIC) codes. 2015 National Association of Certified Valuators and Analysts (NACVA) 12

Although, for a CEO, you may sometimes use nationwide data without adjusting it since searches for new CEOs are often nationwide. IV. Size - For licensed professionals and employees who are not senior executives with companywide responsibility, we typically draw comparability data base on the individual s years of experience. Examples of this would be dentists and accountants. For senior-level executives who have companywide responsibility, we typically want to draw comparability data based on company size rather than years of experience. For most businesses, size is measured by gross revenue. In some industries, such as banking, size may be measured by total assets. For hospitals or nursing homes, size may be based on the number of beds. Try to draw data from companies that are no more than 50% larger or 50% smaller than your client. Then be careful in size-adjusting that data. You will notice that executive compensation amounts do not move upward or downward in the same percentages as company size. For example, when a company s revenue increases by 10%, the CEO s pay may rise only 2%. Regression analysis is used to identify relationships between pay level and years of experience or company size. Example The chart below shows comparability data for the CEO of a hypothetical management consulting firm with $10 million of annual revenue located in San Francisco. Revenue 10 th Percentile Median 90 th Percentile $15,000,000 $151,190 $284,068 $460,254 10,000,000 138,837 260,129 421,375 5,000,000 120,667 225,571 365,189 2015 National Association of Certified Valuators and Analysts (NACVA) 13

To obtain data for this sample, we pulled amounts paid by companies with revenue of $15 million to $5 million. Then the software used regression analysis to adjust pay amounts from those companies to the size of our subject company. These amounts are total cash compensation, so they include base salary and cash incentive bonuses. Welfare benefits and retirement plan contributions made by the employer are not included. The amount at the tenth percentile might be appropriate for a poor performer or perhaps someone who has cut back their duties. The amount at the ninetieth percentile is for top performers. Based on your understanding of the facts, you must decide which amount in that range is appropriate. This is where we carefully consider the multiple duties and demands placed on the individual and the skills required to perform the duties successfully. A Potential Problem with Comparability Data It is widely-recognized that compensation databases and surveys may be helpful in providing averages and ranges of pay for similar positions at similar companies. Using this comparability data for benchmarking will be most useful in determining market-based pay if members of the comparative group are truly comparable to the individuals under evaluation. The comparative group should be composed of executives performing similar duties at companies that are in the same industry and are similar in size to your client. Adjustments can be made to account for differences in important factors. Surveys often fail to account for three critical factors. The first of these factors is the differences in the duties performed by a single individual. For example, some officers wear multiple hats; others have more narrow areas of responsibility and work within multiple layers of management. The second factor is the differences in the companies. For example, some companies included in surveys are growing and profitable, others are not. Surveys may also include companies operating in bankruptcy. Some companies are S corporations which tend to under-pay their shareholders for tax avoidance reasons. 11 And the third factor is the differences in the compensation packages. Some companies offer stock options and rich benefits packages; others do not. Even with these inherent weaknesses, surveys should be considered. 11 The U.S. Government Accountability Office (GAO) conducted a study of tax compliance among S corporations. On December 15, 2009, the GAO published the results of its study, saying that there were nearly 4 million businesses operating as S corporations in 2006. The published report also said that some S corporations failed to pay adequate wages to shareholders for their labor for the corporation. It went on to say that inadequate shareholder wage compensation is a significant issue. Using IRS data, GAO calculated that in the 2003 and 2004 tax years, the net shareholder compensation underreporting equaled roughly $23.6 billion. More information about the study can be found at: http://www.gao.gov/products/gao-10-195 2015 National Association of Certified Valuators and Analysts (NACVA) 14

Outliers 2015 National Association of Certified Valuators and Analysts (NACVA) 15

After carefully making market comparisons, you may find that your subject was paid well above or below the average market amounts. But this may not necessarily mean that he or she received unreasonable compensation. After all, some people have to be above or below average, or it s not an average. Rather than focus entirely on adjusting to median or mean market rates, I suggest focusing on some other questions: Did he or she provide aboveaverage results? Did the business get what it paid for? There are some people whose achievements are so great that they deserve compensation above that of their peers. If an individual is truly unique because of special skills, duties or spectacular results, then his or her replacement compensation may need to be determined by means other than comparability data. Some people are simply off-the-chart. Carefully explain in your report why that s your opinion and decide how to quantify the replacement costs of the above-normal results. For example, after one CEO s above-normal growth rate has been compared to industry averages, the value of the excess growth may be quantified by applying the profit margin. If your client grew 30% and its peers grew only 10%, you can determine the value of the additional 20%. Then, the replacement cost must be determined. In other words, if that CEO had not produced 30% growth, how would the company have generated that additional revenue and how much would it have cost to do so? In the examples mentioned earlier, the replacement cost of the executive who raised capital on Wall Street could be quantified. Careful analysis would provide an estimate of how much the company would have otherwise spent to raise those funds. The amusement park could estimate the advertising costs it would have otherwise incurred to attract the additional customers if it had not had the celebrity CEO. In Allen L. Davis, et al v. Commissioner, T.C. Memo 2011-286, a shareholder who generated extraordinary growth for a payday lending company earned $37 million of compensation one year. An analysis of their financial statements and some projections would reveal what the replacement costs could have been. One apparel retailer had an ambitious goal of increasing sales each year. Due to economic conditions, most of their competitors said they were content to hold our own. An analyst decided to normalize the owner s total compensation based primarily on the client s growth rate. Using comparability data which included only base salaries, the analyst began by using an amount equal to the median of the range for the owner s base salary. The actual growth rate was then used to compute an appropriate incentive bonus for each year. Her bonus was computed by tripling the growth rate, and then applying that percentage to her base pay. When sales grew by 16%, her bonus was 48% of her base salary. In another situation, a company s primary goal was to maximize return on equity. When the company s return exceeded the median return on equity for its peers by 30%, the analyst 2015 National Association of Certified Valuators and Analysts (NACVA) 16

determined that the owner s replacement cost could be 30% more than the median cash compensation of his peers. Peer group Client Return on equity 10% 13% CEO Compensation $300,000 $390,000 Another owner achieved above-market results in three key areas: profitability, growth and customer satisfaction. Believing that these results were rare, the analyst determined that the best assessment of her replacement cost was the amount found at the 90 th percentile of the comparability data range. 12 In Aries Communications, Inc. & Subs v. Commissioner, T.C. Memo 2013-97, the court recognized that the business owner had personally facilitated the sale of company assets for $6 million more than the buyers original offers. Experts who testified in this case disagreed on how to quantity this result and this shows that there is not one correct way to bring this into perspective. In some situations, the value of an outstanding achievement cannot readily be quantified and thoughtful judgment must be used instead. Supporting a conclusion in these situations may be very difficult. Of course, if you can quantify the cost through some understandable and logical methodology, it will be more readily accepted than an unsubstantiated opinion. On the other hand, there are other owners whose accomplishments are so modest that their replacement cost may be below the tenth percentile. This situation may occur when a semiretired owner has delegated most of his or her duties to other employees. Do Business Owners Work Harder? There is some conflicting evidence... Professors at Harvard Business School, the London School of Economics and Columbia University's business school examined the schedules of 356 chief executives in India and found that family CEOs worked 8% fewer hours than managers without genetic ties to their companies. The researchers found similar disparities in Brazil, Britain, France, Germany, Italy and the U.S. The incentives and risks that motivate professional CEOs to burn the midnight oil just might not be a factor for family CEOs, said Raffaella Sadun, a Harvard strategy professor and one of the study's authors. 12 These examples assume that the results were due to the CEO/owners efforts, which is not always the case. 2015 National Association of Certified Valuators and Analysts (NACVA) 17

"The consequences of underperforming are very different," she said. "How easy is it to fire your brother?" From Do CEOs of Family-Owned Businesses Work Less? by Rachel Feintzeig, Wall Street Journal, March 5, 2014 However, Michael Sack Elmaleh has written that owners work with more passion and would therefore be expensive to replace: The substitution approach is based on the premise that a non-owner employee can replace on owner-employee. In the context of most small closely-held businesses this is a false premise. Generally, owner-employees assume indispensable functions and responsibilities that non-owner employees would be unwilling to accept without significant increases in compensation. The indispensable functions and responsibilities performed by owner-employees are of two related kinds. First, in most small, closely held firms the owner-employee performs multiple functions, while non-owner employees are more likely to perform specialized duties. Second, an owner-employee assumes a fiduciary responsibility for the business that non-owner employees are simply unlikely to assume (absent an ownership interest). From Distinguishing Owner Compensation from Profit: In Search of a Responsibility Premium, by Michael Sack Elmaleh, The Value Examiner, July/August 2008 Professional Goodwill Relationships are powerful in some industries where owners have regular contact with customers, referral sources, suppliers and employees. The owners may have many such relationships and have outstanding reputations in the industry. These intangibles are valuable and may be referred to as professional goodwill. When determining the value of a business, it is common to distinguish between professional goodwill, which is an asset of the owners, and enterprise goodwill, which is an asset of the business. It is wise to also consider professional goodwill when determining the value of the owner s services (replacement compensation), and that may be a reason why normalized pay for one person is toward the high end of the range. For some businesses, it can be difficult to convincingly separate the owner from the business in your mind. The relationship may be so close that they almost seem to be one. 2015 National Association of Certified Valuators and Analysts (NACVA) 18

David Wood recommended using a point-scoring method to allocate between the two types of goodwill, rather than concluding that all goodwill is professional or all is enterprise. 13 Just consider whether the process you use to allocate between the two types when determining replacement compensation is similar to that which you use when valuing the business. Guarantor Fees It is common for small business owners to personally guarantee their companies debts and leases. This is a valuable service since many companies could not otherwise obtain financing in the current lending market. But business owners already have considerable risk and do not want to assume more liability. When they do, this should be reflected in their pay. (Imagine for a moment how much you would want to be paid if the owner asked you to provide that guarantee!) In some situations, a fair fee may be as much as 10% (or more) of the amount guaranteed. If no separate guarantor fee is paid, the replacement compensation should be increased to include an appropriate amount for this service. In one situation, an owner s replacement compensation was increased because the owner had personally guaranteed some of the company s debt which had no collateral. By having his personal guarantee, the company had gotten a much lower interest rate from the lender than it would have otherwise. The valuator decided to increase the owner s replacement compensation by half the amount of interest that the company had saved by having the owner s personal guarantee. However, it is usually not that simple since most lenders will no longer even consider an unguaranteed loan if the company does not have enough hard assets or receivables to offer as collateral. The courts have addressed the value of a personal guarantee, and acknowledged it as a valuable service. 14 Yet there is not a well-established, one-and-only method of computing the amount of the guarantor fee. Each situation must be considered individually with whatever reliable information is available. Certainly determining a guarantor fee requires careful consideration of both the amount of the exposure and the risk. A starting point may be to compare the interest rate to whatever you are using as a risk-free rate. Then consider key factors: How important was the debt to the company? Was the personal guarantee required by the lender? How many 13 Goodwill Attributes: Assessing Utility by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007 14 See Herold Marketing Assoc., Inc. v. Commissioner, 77 T.C.M. 1306 (1999); Labelgraphics, Inc. v. Commissioner, 76 T.C.M. 518 (1998), aff d, 221 F.3d 1091 (9 th Cir. 2000); Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5 th Cir. 1987); R.J. Nicoll Co. v. Commissioner, 59 T.C. 37 (1972); Acme Construction Co. v. Commissioner, T.C. Memo. 1995-6; BOCA Construction, Inc. v. Commissioner, T.C. Memo. 1995-5; Eberl s Claim Service, Inc. v. Commissioner, 77 T.C.M. 2336 (1999). 2015 National Association of Certified Valuators and Analysts (NACVA) 19

people guaranteed the debt? Did the guarantor put up collateral, such as a residence? Did the guarantor have the ability to pay, if necessary? Catchup Pay It has long been common for owners to get catchup pay for earlier years. If a business owner was underpaid when the business was getting started or cash-flow was weak, he or she may be entitled to catch-up pay later. 15 The directors should memorialize such arrangement in their minutes and consider including the liability on the balance sheet, but they often do not. For nonqualified deferred compensation ( NQDC ), beware of Internal Revenue Code Section 409A. The effects of Section 409A are far-reaching, because of its broad definition of deferral of compensation and because of the severe tax consequences of non-compliance. If you have a large normalizing adjustment for NQDC, consider sending the client a letter suggesting that they call this to the attention of their tax advisor. It may not be your role to provide tax advice, but do your client a big favor and suggest that they tell their tax advisors the same facts they tell you. If the NQDC has been accrued on the books each year as it was earned, remember to consider that expense accrual when computing your normalizing adjustments. However, there is a certain twist to considering an individual s prior pay levels. On the one hand, someone s prior pay can suggest what they deserve in a later period. For example, imagine someone who was paid $1 million annually in earlier years. It might be assumed that his or her services are also worth $1 million annually now. On the other hand, someone s earlier pay level might suggest that he or she deserves catchup pay. For example, someone who was paid $50,000 in an earlier year may deserve $1 million of current pay now, plus $950,000 of catchup pay for that earlier year. My point is this: if someone was paid a modest amount in an earlier year, does it suggest that they deserve the same modest amount now? Or does it suggest that they now deserve some catchup pay for that earlier year? Did Unrelated Shareholders Approve the Pay in Arm s Length Negotiations? Remember that compensation amounts determined by arm s length negotiations among knowledgeable shareholders may be considered to be reasonable based on an agreement among parties with adversarial interests. In Allen L. Davis, et al v. Commissioner, T.C. Memo 2011-286, the Tax Court considered an unusual set of facts. Mr. Davis and his two adult sons were shareholders of an extremely profitable S corporation but there was strife and litigation among the family members. When Mr. Davis exercised a stock option that he had been granted less than two years earlier, the company deducted almost $37 million of compensation expense. The Tax Court ruled that the amount was not unreasonable based primarily on the facts that Mr. Davis sons had agreed to the option grant and they had interests that were adversarial to those of their own father. 15 For an example, see Choate Construction Company v. Commissioner, T.C. Memo 1997-495. 2015 National Association of Certified Valuators and Analysts (NACVA) 20

The Davis ruling is distinguished because the court did not rely on the usual factors, comparability data or the hypothetical investor test. Instead, the court decided that Mr. Davis compensation amount must have been appropriate since the other shareholders had agreed to it when the option was granted. The opinion states, The granting of the Allen Option was reasonable because it was not a one-sided bargain. In effect, the court relied on the other shareholders to determine whether the compensation was reasonable. In May 2013, the Eleventh Circuit affirmed the Tax Court s decision in Davis. Using ROE to Confirm Your Opinion The hypothetical investor test is a method of assessing a business owners compensation level. You would not use this method often to normalize compensation in a business valuation although you might use it as a sanity check. The hypothetical investor test looks at historical financial statements and uses the net income and shareholders equity to determine the return on equity. 16 If that return is high enough to satisfy a hypothetical investor or shareholder, then that may suggest that the owner earned all of his or her pay. In other words, to oversimplify it a little bit, if the company paid and deducted a certain amount of compensation and the company s ROE was similar to that of its peer group, then it may be presumed that the people running the company were not overpaid or underpaid. Again, this is not the methodology you would typically use to normalize the owner s compensation, but it is an interesting approach to consider for confirming your opinion. Employee Benefits Be sure to identify the whole compensation package, including the employer s retirement plan contributions and welfare benefits. Determine whether the subject is provided benefits comparable to industry standards and adjust if necessary. Mistakes Business owners are human and they all make mistakes. So you may be tempted to assume, as a starting point, that your subject made mistakes that were comparable to those of the peers whose pay is included in the comparability data. But what if your subject made bigger mistakes, such as foolish decisions that resulted in harmful publicity and/or litigation? Industry Codes NAICScode.com provides user-friendly access to a list of 2007 NAICS codes, and provides the IRS business activity code and SIC code for each NAICS code. The database is word searchable and allows use of and or or as combining terms. It also gives industry descriptions, 16 The courts have often used net book value in computing return on equity, although an argument could be made for using fair market value instead, if fair market value is known or can be estimated as in Elliotts, Inc. v. Commissioner. 2015 National Association of Certified Valuators and Analysts (NACVA) 21

examples, and cross references to similar NAICS codes. The site is provided by Axiom Valuation Solutions and they are looking into updating to the 2012 NAICS codes. SICcode.com now cross-maps between SIC and 2012 NAICS codes. Collateral Damage As professionals, we always regard our work as highly confidential, and we expect our reports to be used only for their stated purposes. Yet somehow, our reports may eventually be seen by those we least expect. Although we cannot control these situations, it may be of great value to remind clients about the sensitivity of this information. Consider these examples: If your work product is somehow seen by tax authorities, they may propose tax assessments for unreasonable compensation based on your adjustments and explanations. This could result in new liabilities for income taxes, payroll taxes, interest and penalties, which were not considered in the valuation report. For S corporations, an IRS adjustment to one shareholder s pay may result in distributions for that period becoming disproportionate. S corporations should make distributions to shareholders on a pro rata basis (based on stock ownership) to avoid creating two classes of stock. An increase in one shareholder s pay, with a corresponding decrease in that shareholder s distribution, can create disproportionate distributions. In a severe case, such disproportionate distribution could terminate the company s S status as of that earlier year. Other shareholders may object when they see that another co-owner was overpaid and thereby received disguised dividends. It may not be an issue immediately, but in a few years, the relationships among the shareholders may turn ugly. You could be deposed in a shareholder dispute years after your report was issued. Lenders, such as banks, could claim that they had been given misleading or inaccurate financial statements. Be especially careful with catchup pay that is owed to a shareholder if it is not reflected as a liability on the balance sheet! Be mindful of prospective buyers. We hope they sign nondisclosure agreements and then honor those agreements. But one business owner near the west coast learned a valuable lesson the hard way. The owner showed a prospective buyer a report stating that he and his wife had been receiving large paychecks from the company but not really having to do much work. Rather than making an offer to buy the business, the prospect returned to his office and contacted the IRS in hopes of receiving a cash reward under the IRS whistleblower statute. Some emails get forwarded and forwarded again. For example, I once emailed a draft of a report to a doctor so he could confirm the facts. The next day, I began getting calls from attorneys and bankers saying, I read your report. The doctor had forwarded the email to one person, who promptly forwarded it to at least three others and on it went. (By the way, it was noteworthy that each of the callers said they had read my report even though it was clearly marked as a draft.) 2015 National Association of Certified Valuators and Analysts (NACVA) 22

Reference and Recommended Reading Ronald L. Seigneur and Kevin R. Yeanoplos, Reasonable Compensation: Application and Analysis for Appraisal, Tax and Management Purposes, (Business Valuation Resources, LLC, 2010) Michael A. Gregory, Business Appraisals and the IRS, (Birch Grove Publishing, 2013) Bruce R. Ellig, The Complete Guide to Executive Compensation (3 rd edition), (McGraw-Hill, 2013) Robert Pastore, Stock Options: An Authoritative Guide to Incentive and Nonqualified Stock Options (2nd edition), (PCM Capital Publishing, 2000) Training and Further Information ERI Economic Research Institute offers free, online courses through their Distance Learning Center (erieri.com). There are excellent courses on compensation topics, including analyzing salary surveys, job evaluation, paying for performance, quantitative methods used in compensation, regression analysis in compensation administration and Daubert criteria. The information is available without charge, but if you want to complete an online exam for any course and receive CPE credit, there is a charge (usually $49 per course). Training and whitepapers are also available from WorldatWork (formerly the American Compensation Association). See Worldatwork.org. Summary Be sure your facts, methods and conclusions are well documented and explained. Before finalizing your report, ask yourself the questions you might be asked if you and the report ended up in court. Examples of such questions: Were you provided complete and accurate information? (Remember that the parties you talk to may have biases.) Did you use reliable sources for comparability data? Did you use accepted methodology? (And again, using comparability data is the most commonly-accepted methodology for normalizing compensation amounts.) Could you confirm your conclusions with respect to normalizing the owners compensation? Your analysis and conclusions will be clear to you when you finalize your report. Be sure they are clear and make sense to others who read the report, even if they do not understand the client s business, and your report will be less likely to end up in court. 2015 National Association of Certified Valuators and Analysts (NACVA) 23

Please Note This material provides only an overview of a complex subject. This information is provided to encourage thoughtful discussion and is not intended to be advice for any specific situation. Nothing in this material should be considered to be legal advice or tax advice. Thank you. Stephen D. Kirkland, CPA, CMC, CFC, CFF is a compensation and tax consultant. He serves as an expert witness in U.S. Tax Court and other courts on issues involving (un)reasonable compensation. Stephen can be reached at (803) 477-5973 or Stephen.Kirkland@AECG.biz. 2015 National Association of Certified Valuators and Analysts (NACVA) 24