Reasonable Compensation

Compensation

AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

One of the most subjective and discretionary expenses for many small closely held businesses or professional practices is owner compensation. Reasonable compensation is a key assumption in the valuation model as it can have the most impact on the profits of the closely held business. This is due to the fact that compensation recorded in the Company’s books and records and presented in the financial statements is not always at market rates and it is not required to be. For example, owner compensation may have been established for tax planning purposes. An accepted interpretation of reasonable compensation under the fair market value standard is the salary necessary to hire a non-owner replacement employee of equal experience, education and skill, etc.(1)

Why is Reasonable Compensation Important?

  • If owner compensation is above or below market it can affect the assessment of the subject company’s performance when comparing against industry benchmarks.
  • An understatement of reasonable compensation will lead to an overstatement of enterprise value and enterprise goodwill.
  • An overstatement of reasonable compensation will lead to an understatement of enterprise value and enterprise goodwill.
  • A reasonable compensation analysis can address the concept of personal goodwill. The analysis may show that the owner is being paid above market because he or she is wearing many hats in the company, and is being compensated appropriately. The “above market” compensation translates into the personal goodwill.
  • It can an affect spousal and /or child support.

Things to Remember When Determining Reasonable Compensation:

  • Determine what the owner/manager actually does for the Company.
  • Find an industry benchmark. A good place to start is by looking at the information available regarding the Company’s industry. There are many sources such as Statistics Canada, industry associations; certain fee based and free databases, human resource specialists, etc.
  • Determine how the above industry data is compiled and what their limitations are.
  • Does the owner have control over the business or is he/she a minority shareholder?
  • Look at the factors that the courts have developed to provide guidance on what is reasonable compensation.

Some Factors to Consider when Determining Reasonable Compensation:

The business valuator can look to the US Tax Courts for considerable guidance on reasonable compensation. Some factors to consider are as follows:(2)

  • Employee’s qualifications
  • Nature, extent, and scope of the employee’s work
  • Size and complexity of the employer’s business
  • Comparison of salaries paid with the employer’s business gross and net income
  • Prevailing general economic conditions
  • Comparison of salaries with distributions to shareholders and retained earnings
  • Prevailing rates of compensation for comparable positions in comparable companies
  • Employers salary policy of the employer to all employees
  • Amount paid to employees in previous years
  • Employer’s financial condition
  • Whether employer and employee dealt at arm’s length
  • Whether employee guaranteed employer’s debt
  • Whether employer offered a pension plan or profit-sharing plan to employees
  • Whether the employee was reimbursed by the employer for business expenses that the employee paid personally

Independent Investor Standard:

The courts have also looked at the concept of the Independent Investor Standard. The concept requires an analysis to determine whether an independent investor in the subject business would be considered to be receiving a satisfactory rate of return on his/her investment, at the current level of owner compensation. If the rate of return is considered satisfactory, then the amount of compensation paid to the owner/manager would be considered reasonable. The purpose of the valuation, the type of valuation report being prepared and the amount of compensation involved will factor into the level of analysis required to determine what constitutes reasonable owner/manager compensation.

(1) Medical Practices: A BV Rx, Journal of Accountancy, November 2005 (2) Mad Auto Wrecking, Inc. v Commissioner, TC Memo, 1995-153, 69 TCM 2330, April 5, 1995.

Restaurant woes: Serving up a disappointing retirement outlook

RestaurantWoes

AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

It seems odd that a business owner would work his or her whole life on their business and then determine the business’s value based on what they “think “the business is worth, or an industry rule of thumb. If the sale of your business is going to fund your retirement you should know what your business is worth.

Mr. Jones, A Quick Service Restaurant owner, has determined (based on industry rules of thumb, and conversations with friends) that restaurants like his are sold for multiples of between one and three times seller’s discretionary earnings (“SDE”), plus fixtures, equipment and inventory. SDE is defined as earnings before interest, taxes, depreciation and amortization, plus owner’s compensation. Mr. Jones knows his average SDE for the past five years has been $300,000. He “knows,” therefore, his business is worth $900,000 plus the value of the fixtures, equipment and inventory of $100,000 (owner estimate), or $1 million. Mr. Jones is 50 years old and has based his retirement plan on the restaurant value of $1 million. Mr. Jones and his wife like to spend money and the restaurant represents over half of their net worth.

A valuation would have determined the following:

  • The restaurant is 20 years old, looks its age and certain equipment needs to be replaced within the next two years.
  • The restaurant does not have a state of the art Point of Sale system (“POS”).
  • The rent being paid for the premises is below market rent. Rent expense is expected to increase significantly when the current term expires. This will reduce SDE in the future.
  • The building that the restaurant operates from has new owners. There is no guarantee that the new owners will want to lease the premises to a restaurant when the current lease term expires in three years.
  • The minimum wage is expected to increase significantly in the next year. This will reduce SDE in the future.
  • Parking available for restaurant patrons is maxed out.
  • Population growth is expected to be two per cent for the next five years and income is expected to grow at two per cent in the same time period.
  • The SDE information is based on the income tax returns prepared by a non-designated accountant.

Contrast the above scenario with another Quick Service Restaurant, with the same SDE and the following circumstances:

  • The financial statements of the company are reviewed by a professionally designated accountant.
  • Management has recently had a valuation report prepared. SDE is taken from this valuation report.
  • The restaurant is located near an NHL arena.
  • Population growth in the next five years is expected to be 15 per cent, and income growth is expected to be eight per cent over the same time period.
  • The restaurant is four years old and has six years left on its lease, with two five-year renewal options.
  • The restaurant’s POS system is new.
  • It is easy to see that if we assume the restaurant in scenario 2 has the characteristics of a restaurant selling at multiples of three times SDE plus the value of the fixtures, equipment and inventory, and we estimate that value to be $1 million, then the value of the restaurant in scenario 1 is significantly less than $1 million. It is likely Mr. Jones restaurant would be worth less than $400,000.

Clearly there is a gap between Mr. Jones’ estimate of the value of his business and the actual value.

  • The first thing Mr. Jones has to do is get the restaurant valued by a valuation professional.
  • He needs to talk to the landlord and determine whether they will renew the lease. If the landlord is not willing to renew the lease, then it is unlikely Mr. Jones will be able to find a buyer.
  • If the lease will not be renewed, Mr. Jones may decide to keep operating the business as is, invest his SDE in investments outside the restaurant and turn the lights off when the lease expires in three years. (1)
  • If the lease will be renewed, Mr. Jones will have to decide if he wants to invest the time and money necessary to maximize the value of the restaurant. Last spring, Ottawa’s Calabria Restaurant in Centretown announced it was closing after 42 years of family operation, after it was given notice by its landlord that its lease would not be renewed. In September 2013, the Mayflower Restaurant on Elgin Street, in Ottawa, also announced it would close, after 35 years, due to lease issues. Mr Jones should be prepared.

Your business may not be worth as much as you think it is...yet

BusinessWorth Do you know how much your business is worth? And by worth, I mean what price it would realize if it was for sale today. Many times small business owners think their business is worth more than it currently is. This is often referred to as the value gap.

If your business represents a significant part of the funding for your retirement, you will want to determine the amount of this gap sooner rather than later.

Some reasons for the value gap:

  • Much of your business value may be due to your expertise, relationships and reputation. Ask yourself this question: Can your cash flows/earnings be replicated in the future without your presence? If not, your business has little value to a purchaser.
  • Profitability may be due to less than market rates being paid for management services, rent, etc.
  • Your financial performance may be below industry averages. Buyers will examine key ratios to see how your business compares to the industry average.
  • Your Company has not kept up with needed capital improvements, and/or repairs and maintenance requirements.
  • You have been relying on rules of thumb or formulas provided by friends or associates.
  • Value changes over time due to changes in economic and industry circumstances.

An up-to-date business valuation will identify the above factors and the amount of the value gap. This is an essential starting point for a successful retirement plan.

An up-to-date valuation will also help in being prepared for unforeseen circumstances such as divorce, death, or shareholder disputes.

Rick Evans is a Chartered Accountant, Certified Public Accountant (CPA-California), Accredited in Business Valuation (ABV), Certified in Financial Forensics (CFF), Certified Valuation Analyst (CVA) and a Certified Fraud Examiner (CFE). Follow McCay Duff LLP on Twitter: @McCayDuffLLP

The Income Approach to Determining Business Value

Post5The income approach is often the primary approach used for valuation and is used in the valuation of most operating companies.

The income approach discounts the expected future cash flows (returns on investment) to present value using an appropriate rate of return for the investment.

Future cash flows are typically based on the net after-tax cash flows expected to be generated by the business.

The discount rate (or rate of return) used should reflect the degree of uncertainty or risk associated with the future returns and returns available from alternative investments. The higher the perceived uncertainty or risk results in a higher expected rate of return, which results in a lower value someone would be willing to pay for the investment.

The two primary methods of the income approach to valuation are the Discounted Cash Flow and Capitalization of Cash Flow Methods.

Discounted Cash Flow Method:

The Discounted Cash Flow method discounts future cash flows to present value using an appropriate discount rate or rate of return. This method is more appropriate when earnings are expected to be materially different in the future, due to changes in factors such as business structure and economic/industry conditions.

Future cash flows are projected for a specified number of years and then projected to grow at a constant rate in perpetuity.  The number of years to use in the projection would be the number of years until the business achieves a sustainable operating level.

An example would be when a business has just completed a major expansion and it is not expected to attain a mature operating level until after three years. At the end of three years a single measure of future cash flows is selected on the basis of the expected stabilized cash flows for use into perpetuity. This is often referred to as the terminal value.

The discount rate is then determined and applied to all future cash flows to determine an estimated value.

 

Capitalization of Cash Flow Method:

The Capitalization of Cash Flow method uses forecasted cash flow for the next period, which is converted to present value using an appropriate capitalization rate.  This rate is equal to the discount rate less the expected growth rate in perpetuity.  This method is often used when a Company’s future operations are not expected to change significantly from its current normalized operations and when future returns are expected to grow at a relatively predictable rate.

This method is also used when the subject company does not have reliable projections.

The forecasted cash flows for the next period are based on prior historical cash flows and the projected cash flows for the next period. The cash flows used should be representative of the expected future performance of the company.

The capitalization rate is applied to forecasted cash flows to estimate value.  In other words forecasted cash flows divided by the capitalization rate equals value.

 

Image Courtesy of jayofboy @ Stock Exchange

 

The Treatment of the Trapped in Capital Gains in the Valuation of Holding Companies

Post1

The issue of how to treat the trapped in capital gains most often shows up when applying the Adjusted Net Asset Approach to valuing a holding company.

The Adjusted Net Asset Value Approach is typically used when valuing a real estate or investment holding company. This approach results in the book value of the assets and liabilities being restated to reflect their fair market value. The adjusted net book value of the Company is then computed by subtracting the fair market value of the liabilities from the fair market value of the Company's assets.

There is an inherent built-in tax liability on the increased net asset value. Should this  built – in tax liability be factored into the fair market value of the shares of the company as determined by the Adjusted Net Asset Value Approach described above?

It has been generally accepted, by business valuation professionals in Canada and the United States, as well as CRA, the U.S Tax Court and the U.S Court of Appeals that a reduction/discount is warranted since a willing buyer and willing seller would take into account the built – in tax liability when arriving at a purchase price in the open market.

While the authorities noted above are in general agreement that a discount for the tax on trapped – in gains is appropriate, the amount of the discount is not generally accepted.The business valuator performs his valuation in a notional (hypothetical) market, which requires us to make assumptions regarding the amount of the reduction/discount.

The following are some suggested approaches to determining the amount of the discount:

  1. 100% (“dollar for dollar”) of the tax liability, assuming the immediate sale of the appreciated assets.
  2. Assume the appreciated assets will be held indefinitely. It could be argued that the reduction should be equal to the present value of the lost tax shield when a purchaser acquires a business through the purchase of shares.
  3. A compromise equal to 50% of the tax liability – the hypothetical midpoint of an immediate disposition and holding the asset indefinitely.
  4. An amount recognizing the rate at which the capital gains tax will be recognized, measured as the present value of the built in gains tax liability that will be incurred over some reasonable holding period. A reasonable holding period would be based on the facts and circumstances of the taxpayer.
  5. Other defensible approaches.

 

Conclusion:

In my opinion a reduction/discount to the fair market value of the shares should be made for the trapped – in capital gains tax liability. The amount of the reduction/discount will depend on the facts and circumstances of the case.

 

Image Courtesy of jayofboy @ Stock Exchange

 

The Market Approach Remains a Valuation Touchstone

Post1Abstract: Under the market approach, appraisers use guideline companies to help them estimate the value of a private business. With so many companies in circulation, this approach has become a long-standing valuation touchstone. This article discusses two primary valuation methods that are categorized under the market approach: the guideline public company method and the guideline merger and acquisition method.

The market approach remains a valuation touchstone

Under the market approach, appraisers use guideline companies to help them estimate the value of a private business. With so many companies in circulation, this approach has become a long-standing valuation touchstone.

Picking a category

Two primary valuation methods are categorized under the market approach. First, there’s the guideline public company method. Under this method, appraisers identify companies whose stock (or partnership interests) is actively traded in the public markets, such as the AMEX or NYSE. Then they calculate key financial variables, using the stock price and a variety of pricing multiples such as price-to-revenue, price-to-net income and price-to-book.

Financial variables may be calculated for a variety of time periods, such as next year’s forecasted performance, the preceding 12 months, or an average of the last five years. The appropriate pricing multiple depends on case specifics and is a matter of the appraiser’s professional judgment.

The subject company’s fair market value equals the pricing multiple times the subject company’s financial variable (for example, revenues, net income or book value). Because the guideline public company method is based on individual stock prices, under certain circumstances it generates a minority, marketable basis of value.

The second categorized approach is the guideline merger and acquisition (M&A) method. For guideline transactions under this method, appraisers analyze sales of entire public or private businesses. So this technique typically generates a controlling, marketable basis of value.

Because private businesses aren’t required to disclose sales to the SEC, finding out their details can be difficult. Fortunately, appraisers have access to several proprietary databases (such as Pratt’s Stats, Done Deals, BIZCOMPS and the IBA Market Database) that can identify and analyze private deals.

Once they’ve identified a relevant sample of potential guideline transactions, appraisers calculate pricing multiples relative to key financial variables. Fair market value is a function of the pricing multiple and the subject company’s financial metric (say, last year’s revenues or book value).

Pulling the trigger

The availability of transaction data is a key determinant of whether an appraiser uses the market approach. Pure players (companies that focus on a single target market or offer a limited menu of products) may be hard to come by in the public markets — especially in industries dominated by conglomerates. And some industries lack a meaningful sample of M&A transactions, particularly those involving small niche participants.

In general, the guideline public company method makes more sense if the subject company is large enough to consider going public and when valuing a minority interest in a going concern business. Using this method to value a controlling interest may require subjective adjustments for control.

Conversely, the guideline M&A method is generally more appropriate when valuing controlling interests. But, with proper adjustments and analyses, it can be used to value minority interests.

Other disadvantages of the guideline M&A method are that transaction databases provide limited information about guideline companies, details provided are unverified, and the sales price may include buyer-specific synergies and undisclosed terms (such as installment sales, employment contracts and noncompete agreements).

Reasons for a Valuation

There are many reasons to seek valuation. Seek valuation if you find yourself in a situation listed below.

  • Buying all or part of a business
  • Selling all or part of a business
  • Mergers
  • Corporate or partnership dissolutions or reorganizations
  • Divorce
  • Shareholder/Partner Disputes
  • Buy/Sell Agreements
  • Economic Damages Litigation
  • Estate planning
  • Employee Share Ownership Plans (ESOPS)
  • Income Taxes
  • Charitable Contributions
  • Obtaining financing
  • Allocation of value between share classes
  • Determining the need for life insurance
  • Preparing personal financial statements
  • Fair value reporting

Types of Valuation Reports

We are frequently asked the question: what are the types of Valuation Reports? Here is a summary of each and what these Valuation Reports entail.

Comprehensive Valuation Report

  • Contains a conclusion as to the value of shares, assets or an interest in a business
  • Based on a comprehensive review and analysis of the business, its industry and all other relevant factors, adequately corroborated and
  • Generally set out in a detailed report.
  • This report provides the highest level of assurance with respect to the value conclusion.
  • It would be the equivalent to the Audit.

Estimate Valuation Report

  • Contains a conclusion as to the value of shares, assets or an interest in a business
  • Based on limited review, analysis and corroboration of relevant information,
  • Generally set out in a Valuation Report that is less detailed than the Comprehensive Valuation Report.
  • This report provides a lower level of assurance with respect to the value conclusion.
  • Equivalent to the Review Engagement.

Calculation Valuation Report

  • Contains a conclusion as to the value of shares, assets or an interest in a business
  • Based on minimal review and analysis and little or no corroboration of relevant information.
  • Generally set out in a brief Valuation Report.
  • This type of report provides the least amount of assurance with respect to the value conclusion.
  • Equivalent to the Compilation Engagement.