By Ron J. Anfuso, CPA, ABV, CFF, CDFA, FABFA
I always inform judges, attorneys and clients that business valuation is not an exact science. Two of those areas that require some subjectivity when valuing a business are the determination of reason- able compensation and the risk associated with the business. The means by which to determine how a person is operating a business, and applying surveys and risk factors, are examples of when it requires both objectivity and subjective judgment.
The valuation expert must consider the amount of risk associated with the operation of the business that is reflected in the capitalization rate, the inverse of which is a capitalization multiple. For example, an investor might willingly accept a lower expected return in exchange for lower risk or no risk. The degree to which an investor is willing to trade risk for return depends on the particular risk tolerance and investment goals of that investor. An example of a risk-free rate is a 20-year Treasury Bill. It is consid- ered risk-free because the United States government has yet to default on a Treasury Bill.
After the risk-free rate is determined, the next step is to add market risk. This is objectively determined from data bases subscribed to by business valuation analysts.
The business valuation expert also needs to consider size risk, i.e., size of the company. Size risk is often included in valuations of smaller companies. This is market-driven and determined objectively.
When the company-specific risk is added, however, opinion comes into play. I determine how much risk there is depending on many factors using a worksheet I developed to add weighted percentages. Among the considerations are the general economic condition of the economy as well as the past results of the company’s operations and of the industry in which the company operates.
What Is Reasonable Compensation?
In order to value a business or professional practice, a determination of reasonable compensation must be conducted. The definition of reasonable compensation is based on the principle of substitution. A prudent person would pay no more for an item than the cost of acquiring an equally desirable substitute good or service available in the marketplace. Rather than using the business owner’s actual income for the purposes of (for example) calculating support, the business valuation expert calculates the business owner’s reasonable compensation. A compensation adjustment in business valuation is to substitute the cost of hiring a non-owner from outside to perform the same function and similar services that the operating spouse is performing. Treasury Regulation §1.162-7(b) sets the baseline and states that “the compensation paid [to the owner] may not exceed what is reasonable under all the circumstances”. Under all circumstances means that getting to “reasonable” is a fact-based endeavor that requires gathering substantial information from a variety of sources. It also requires a significant amount of subjectivity.
Calculating Reasonable Compensation
The IRS Job Aid for IRS Valuation Professionals, October 29, 2014, states: “[w]hat amount constitutes Reasonable Compensation might best be viewed as a range because of the interpretive nature of the issue.” However, the range must be ultimately narrowed down to one number for each year in the valuation analysis. What factors were given what weight in the final conclusion must be analyzed and documented in case of later litigation.
The numbers can be significantly different when both parties are employing accountants to make calculations. When the numbers vary considerably, it is up to the trier of fact (i.e., the Judge) to determine which expert’s reasonable compensation is more persuasive.
My Initial Step in Determining Reasonable Compensation
Before I begin to perform a valuation, I typically study the income and expense spreads for the last five years, including revenue, expenses and net income. When I see how much income is being generated by examining the bottom line, I can get a rough idea of whether there is a value to the subject business right out of the gate, although I would not have a number yet. If the business is making a considerable amount of money, it’s going to have a higher value. Should it be making less, the value will be less. Businesses and professional practices are valued largely based on how much income they generate to the owner or owners. If the actual business income, after adjustments for perquisites and other necessary adjustments, does not exceed the reasonable compensation, the business value may be limited to its net tangible assets and does not likely have goodwill as defined by California Business and Professions Code §14100 as “The Expectation of Continued Public Patronage.”
I subscribe to several of the most reliable databases. Some of these are published surveys based on corporate loan applications, which contain financial statements that are submitted to banks. Risk Management Associates (RMA) is one such source considered by forensic accountants. Their surveys show the officers’ compensation as a percentage of gross revenue. You can take the company by standard industrial classification code (SIC) and find a similar business that is in the same range of revenues as the subject company. Then you take the gross revenues of the business you are valuing and multiply the revenue by that percentage to estimate the total reasonable compensation for all officers. You do have to take corporate loan data with a grain of salt because when businesses submit loans, they want to show their books as a healthy company. Therefore, their books may be inflated. One reason these surveys have value, however, is because the books show the total officers’ compensation as a percentage of the gross revenue of the business.
The source I most frequently use is the survey published by Economic Research Institute (ERI). Their survey contains executive compensation including salaries and other forms of compensation. The database can be searched by geographic location and gross revenue of the business and they provide the arithmetic mean, median, high and low, and various percentiles. ERI provides a range of salaries of local geographic locations of similar types of businesses in similar situations. ERI shows the dollar amounts for CEOs and COOs, as well as for employees in other categories.
In the next issue of Forensic Accounting Today, I will discuss further the use of databases, including industry-specific databases for law firms, medical practices and accounting firms. I will also cover goodwill and further address how to determine the most accurate reasonable compensation.