Defining reasonable compensation is a fairly simple task. According to Black’s Law Dictionary, it is, “compensation which is consistent with the normal reward for any employee for the work performed or duties that are involved.” However, that definition is not as simple as it may appear. A key word jumps out to any business valuator or reasonable compensation expert – normal. What is a normal reward? What is normal to one may not be normal to another. The compensation for any job title can vary by industry, location, and experience. Normal is a relative term, making it all the more challenging to determine reasonable compensation.
In this post, we will discuss the dangers of not normalizing reasonable compensation when valuing a business, the three approaches to reasonable compensation, and the challenges of using antiquated techniques in determining reasonable compensation.
As a valuator, you need to normalize reasonable compensation to complete your engagement successfully. Owners, and in particular owners of closely held businesses, will often adjust their salary to maximize their business’s profitability or minimize tax burdens. The challenge when performing a valuation on these businesses is determining what normal compensation is for the owner, not the salary they are choosing to pay themselves.
Take one of our recently published Case Studies. Matthew Cassedy, a veteran business appraiser, was brought in by the wife in a divorce. Both the husband and wife were lawyers, but the husband was the single-owner of a medium-sized law firm. The valuation he produced used the market approach, resulting in his salary being extremely high, leaving the business (a shared asset in the divorce) with no enterprise goodwill. Mr. Cassedy was brought in and was able to produce a far more reasonable normalized figure for the husband’s compensation.