Why these valuations pose challenges for experts

Owner replacement compensation refers to the amount an unrelated person would be paid for performing the same duties that an owner performs at the subject company. It includes salaries and commissions, payroll taxes, benefits and perks. Estimating replacement compensation is especially challenging when owners receive noncash perks, such as stock or stock options. Here is a brief look at some common questions related to replacement compensation.

Q: How does owners’ compensation affect value?

A: The more owners pay themselves, the lower the company’s reported earnings will be. Value typically is based on earnings or some income stream that is affected by owners’ compensation. Unless adjustments are made, above-market owners’ compensation lowers a company’s value (and vice versa).

Regardless of whether valid reasons exist for above- or below-market compensation, appraisers customarily adjust for reasonable replacement compensation to accurately value a controlling interest. However, valuators generally don’t adjust for replacement compensation when valuing a minority interest. That’s because minority shareholders lack the requisite control to alter owners’ compensation.

Q: Why might actual and replacement compensation differ?

A: Actual compensation often differs from replacement compensation. Differences may be justified – for example, if the owners personally guarantee the company’s debt or possess advanced skills and training that warrant higher salaries.

Sometimes owners have tax incentives to tinker with their compensation. A C corporation might pay above-market compensation in lieu of paying dividends, because the earnings of a C corporation (from which dividends are paid) are taxed at the corporate level and then dividends are taxed again at the personal level. Conversely, an S corporation or partnership – which isn’t taxed at the corporate level – might undercompensate its owners and instead make larger
distributions to them, which minimizes payroll taxes.

The IRS and local taxing authorities are on the watch for these tax avoidance techniques. A valuator is sometimes called in to defend owners’ compensation levels for tax purposes.

Q: When is replacement compensation an issue?

A: Replacement compensation is a major contention point when a marital estate includes a private business interest. The owner-spouse’s compensation factors into the value of the business, as well as into alimony and child support payments.

Minority shareholders also may dispute replacement compensation. For example, the adjustment for reasonable replacement compensation was a major issue in a recent minority shareholder dissension case, Hubbard v. Phil’s BBQ of Point Loma, Inc.

Here, the California Southern District Court upheld the trial court’s combined replacement compensation estimate of $610,000 for the CEO, COO and a market consultant, based on Economic Research Institute (ERI) executive compensation surveys. To arrive at this estimate, three court-appointed appraisers – one nominated by each side and the third nominated by the first two appraisers – submitted a single appraisal report. Business Valuation Newsletter | June 2013

On appeal, the plaintiff hired a fourth expert who unsuccessfully claimed that executive replacement compensation for these executive functions should be only $195,000, based on Bureau of Labor Statistics (BLS) data for California. Overall, the court accepted the three experts’ joint appraisal – including the adjustment for replacement compensation.

Q: What sources support replacement compensation estimates?

A: Besides ERI and BLS publications, other common sources of compensation data include, but are not limited to:

  • Salary Guide (Robert Half International),
  • Annual Statement Studies (The Risk Management Association),
  • Statistics of Income: Corporation Income Tax Returns (a federal government publication),
  • Executive Compensation survey (Compdata Surveys), and
  • Relevant trade association publications and information from executive recruiters.

Valuators need accurate job descriptions before researching these sources and also can consider personal factors such as the owners’ qualifications, age, health and hours worked. External factors – such as company size and financial condition, geographic location, industry trends, and economic conditions – also come into play.

Q: Who can objectively estimate replacement compensation?

A: Owners’ compensation is one of the biggest, most subjective expenses on the books because what’s “reasonable” often is in the eye of the beholder. But experienced valuators know how to support their replacement compensation calculations with thorough, well-founded research that’s likely to withstand IRS and court scrutiny.