What is Reasonable? Owners’ Compensation Draws Scrutiny in Determining Business Value.

There is a strong tax incentive for profitable, closely held C corporations, to distribute most, if not all, of their earnings to their owners. The Internal Revenue Service will frequently challenge what it considers to be unreasonably large shareholder salaries and to recharacterize some of the executive compensation as a nondeductible, disguised dividend. Conversely, many S corporations will pay their owners a fairly low salary, in an effort to reduce both the employee and employer share of the FICA and Medicare tax.

In a business valuation environment, the valuation analyst must determine what constitutes reasonable compensation in order to properly measure the normalized cash flows generated by the business. The adjustment for owner compensation is often one of the largest normalization adjustments made by the valuation analyst.

An owner’s compensation may consist of many components. The most obvious elements are the base salary, bonus, dividends and/or withdrawals that the business pays to its owner. Other perquisites may also include retirement plans, life insurance, disability insurance, health club memberships, country club dues and other similar items that are provided to the owner. Entertainment expenses may be an owner’s perquisite if the expense is not a reasonable and ordinary business-related expenditure as compared with industry norms. Likewise, automobile expenses, including those related to automobile leases, insurance, repairs and gasoline, may also be considered additional owner’s compensation if such expenses are not specifically related to business operations.

The typical normalization adjustment substitutes the actual compensation paid to the owner or family member with a provision for replacement compensation, at a level that would ordinarily be paid in the marketplace to a non-related individual who would perform similar duties.

In Multi-Pak Corp., T.C. Memo 2010-139, the U.S. Tax Court articulated five factors that it considered in its determination of the reasonableness of a C corporation sole shareholder’s compensation. These same factors are often referenced by valuation analysts in considering owner compensation adjustments. They are as follows:

1.) The employee’s role in the subject corporation
2.) An external comparison of compensation with other comparable companies
3.) The character and condition of the subject corporation
4.) Any potential conflicts of interest
5.) The internal consistency of executive compensation practices within the subject corporation.

In the Multi-Pak decision, the Tax Court gave considerable weight to the fourth factor, from the perspective of a “hypothetical independent investor test”. In explaining it judicial reasoning, the Tax court quoted the Ninth Circuit analysis of the reasonableness of compensation in the Elliotts, Inc. decision (Elliotts, Inc. v. Commissioner, 716 F2.d at 1246) as follows; “if the company’s earnings on equity after payment of the compensation in question remains at a level that would satisfy a hypothetical independent investor, there is a strong indication that the employee is providing compensable services and that profits are not being siphoned our of the company disguised as salary”.

There are several private databases that contain information on compensation levels for various positions within several industries. In addition, trade associations, employment agencies, and other human resource organizations often have resources available related to compensation levels. The valuation analyst will normally perform various quantitative analyses based on published compensation studies, comparison to industry, as well as the independent investor test, to arrive at a conclusion on the reasonableness of owner compensation.

If you need assistance on assessing the reasonableness of your compensation plan, let us know. We can help.

John M. Byrne, CPA/ABV
Mallah Furman, Certified Public Accountants
954-475-3199

Contingent Consideration in a Business Combination

Contingent consideration is a common element of a business combination transaction. These provisions are commonly referred to as “earnouts” and are typically based on revenue or earnings targets that must be reached after the acquisition date. They serve a valid purpose in reducing the uncertainty and risk related to post-transaction performance. Properly structured, earnouts create a win-win situation, reducing risk for the buyer and allowing for the seller to participate in the ongoing success of the business.

Topic ASC 805 requires the fair value of contingent consideration be recognized and measured at the acquisition date. The accounting treatment of contingent consideration can trip up the unwary. Depending on the accounting classification, the fair value of the contingent consideration will be recorded as either a liability or as equity. Therefore, prior to finalizing the deal structure, an evaluation of contingent consideration provisions should be made to determine the potential impact on the Company’s post-transaction financial position and subsequent earnings. If treated as a liability, it may adversely affect an entity’s debt covenants. Contingent consideration treated as a liability must also be remeasured at fair value at each reporting period and any adjustment to fair value will be reflected in earnings. If it is determined that contingent consideration is treated as equity, there is no requirement for remeasurement and no effect on subsequent earnings. Any gain or loss at settlement is recorded as an adjustment to equity through other comprehensive income.

Generally, contingent consideration will be classified as a liability if it requires the buyer to pay cash or transfer other assets upon meeting specific conditions. For example, Company A agrees to purchase Company B for $50 million, and will pay an additional $5 million if total revenues in the year following the acquisition exceed $200 million. This is a clear case of liability treatment.

When the contingent consideration agreement requires the issuance of the acquirer’s own equity shares, you must look to ASC 480 to distinguish between a liability and equity, and potentially review the guidance in ASC 815 to determine if it is to be treated as a derivative.

ASC 480-10 requires a financial instrument to be classified as a liability if it has any of the following characteristics:

It will or may be settled by the issuance of a variable number of the issuer’s (buyer’s) shares, and at inception, the monetary value is based on any one of the following:

A fixed monetary amount known at inception. For example, a provision that includes a fixed $1 million earnout payable in the issuer’s shares, the number of shares determined based on the fair market value of the those shares at a certain date;

Derived from something other than the fair value of the issuer’s shares. For example, requiring the buyer to deliver a variable number of the equity shares based on the movement of the S&P 500 index;

Value varies inversely to the changes in fair value of the buyer’s equity shares in the opposite direction of the value of the issuer’s equity shares. For example, Company A purchases Company B by issuing 1 million shares of its common stock which is trading at $25 per share. They also agree that if the share price of Company A trades below $25 one year from the acquisition date, Company A will issue additional shares to protect against any price decline from the acquisition date value of $25 million.

If the earnout provisions are not within the scope of ASC 480, consideration must be given to ASC 815, Derivatives and Hedging, to determine if the provision should be accounted for as a derivative at fair value. A contingent consideration provision that is a derivative is classified as a liability unless it meets the scope exception that allows equity classification. ASC 815-10-15-74(a) provides a scope exception for instruments that are both (1) indexed to the entity’s own shares, and (2) classified as stockholders equity in the entity’s statement of financial position. If the provision is not indexed to the acquirer’s own equity, it must be classified as a liability (or an asset in the case of a clawback).

The steps in this process can be complex and involve a significant level of judgment. Additional guidance in determining if a financial instrument is indexed to an entity’s own stock can be found in EITF Issue 07-5.
The complexity of contingent compensation agreements combined with the evaluation process under ASC 815-10-15 presents a challenging environment for management. Buyers who are not aware of these requirements may be in for a surprise by the impact earnouts may have on reported earnings in periods subsequent to the acquisition. Let us know if we can help.

John M. Byrne, CPA/ABV
Mallah Furman, Certified Public Accountants
954-475-3199

Government Regulation and Business Value

It its simples form, the value of any business is a function of its cash flows and the risks of realizing those cash flows. Generally speaking, the lower the perceived risk, the higher the value of the business. The converse also holds true.

In the process of estimating the value of an existing business, the risk assessment process is a key factor. Every company is exposed to risk. For example, a company with a high debt level is generally more risky than companies with low or no debt. Companies that have only a few customers that represent a high percentage of total sales are generally deemed more risky than companies that have many customers that generate the same sales volume. Companies that are highly regulated by government agencies may also face high risk levels due to frequent legislation that effects their operations and future cash flows. The auto industry, airline industry, and healthcare, are examples of highly regulated industries.

Successful business owners identify risks and proactively adopt strategies to reduce and minimize risks. Cultivating a diverse customer base is a deliberate action to reduce business risk. Hedging is a strategy often used to reduce risk. The purchase of insurance policies reduces risk of loss through casualty or otherwise.

Government regulations, for most business owners, can present uncontrollable risks. They can appear suddenly, the result of current events and the political pressure to “do something”.

From a valuation perspective, the recent announcement on the prospect of increasing the minimum wage could decrease the value of businesses that rely on low skill employees, those that are earning at or near the minimum wage. The decrease in business value is a result of potentially lower cash flows due to higher labor costs. In today’s fragile economy, a business owner would be hesitant to automatically increase prices based on a forced increase in labor costs. This could result in loss sales to competitors. Most likely, the business owner would cut back in total labor employed so that overall costs remain the same. What happens in this scenario is that fewer people are employed under the guise of helping the low skilled worker earn more.

There have been numerous studies that contradict the politically popular thinking that mandating minimum wage law is good for the economy and good for the low skilled worker.

A more effective approach is for policymakers to focus on policies that generate faster economic growth. A growing economy benefits all workers, while minimum wage policies disproportionately affect low-skilled workers. While I understand that politicians and policy makers believe they are helping workers, research shows the opposite is true. (1)




(1)Richard V. Burkhauser and Joseph J. Sabia, “The Effectiveness of Minimum Wage Increases in Reducing Poverty: Past, Present, and Future, Contemporary Economic Policy 25, no. 2 (April 2007).
Richard V. Burkhauser and Joseph J. Sabia, “Minimum Wages and Poverty: Will a $9.50 Federal Minimum Wage Really Help the Working Poor?” Southern Economic Journal 77, no. 3 (January 2010).

When The Time Is Right, Will You Be Ready?

You’ve heard the line, “When the time is right, will you be ready?” As a business owner, maximizing the sales price of your company may be the most important process that you undertake. It will probably represent the bulk of your retirement nest egg and provide you with the means for a secure retirement. This article addresses key areas that effect business value and what you should focus on to position the company for sale.

The Numbers

An accrual based balance sheet and income statement will be at the top of the list of any serious buyer. The balance sheet is a snapshot of your financial position at a point in time. The trends in your balance sheet offer important clues about your business. It could indicate collection problems with accounts receivable, slow moving or obsolete inventory items, or a shortage of working capital. Adverse trends can indicate to buyers that there is weak or ineffective management, resulting in higher risk and lower value. Identify the key ratios that are relevant in your industry. Typically, working capital, inventory turnover, and debt to equity ratios are significant balance sheet ratios for most businesses. Work at improving your ratios so that they meet or exceed industry standards.

The income statement is a fundamental value driver. Since revenues drive the income statement, make sure that your company’s revenue recognition policies are in accordance with generally accepted accounting principles (GAAP). There are complex rules regarding revenue recognition for firms engaged in construction activities, software sales and support, and contracts with contingent consideration. The income statement will reveal trends on revenues, gross profit percentage, and other operating costs. For a potential buyer, companies with strong or stable growth in revenues are more attractive than businesses that are stagnant or declining. Equally important is the gross margin. Be prepared to explain any significant trends that might be the result of a different product mix or class of customers. When selling your business, one of the components of value is future growth. For a potential buyer, future growth is more believable if the company has a track record of consistent growth in sales and earnings.

People

One of the most valuable assets of your company isn’t even visible on your financial statements, your employees. A well trained workforce, committed to the company and its vision, can be a valuable asset. A well-run company invests in its people, providing them with adequate training, a compensation package that rewards their efforts, and open communication about the company’s direction and their future.

Your customers are also part of the value equation. Are your customers repeat buyers with a history of prompt payment or are they at risk of walking to the competition? A loyal customer base provides comfort to the potential buyer that reduces risk and increases value. All things being equal, a customer base that is relatively homogeneous in sales volume is less risky than a customer base in which one or two customers represent a large percentage of sales. The loss of a single high volume customer can cripple growth and hence, would be considered a higher risk factor.

Often a business owner is so involved in the operations that his absence creates a dangerous void. Successful companies don’t rely on one individual. Owner dominance only increases risk and reduces value. Successful companies have systems and procedures in place and a trained workforce that can handle the normal and unusual situations. Training subordinates and delegating responsibility should be an ongoing process to ensure continuity which increases value.
A strong management team is never satisfied with the status quo. Current operations are scrutinized and evaluated on a regular basis. Budgets and cash flow forecasts are prepared and evaluated against actual results. Proper internal controls are in place and monitored for effectiveness. Improvements to products and services are studied and evaluated.

Processes and Improvements

In the technology age, information is vital. A company’s IT system, tracking information such as inventory levels and product costs, customer sales history, and financial performance, is a critical factor in managing your business. Often the investment in new technology pays for itself in a relatively short period of time.
Capital expenditures for your facility and equipment are necessary to maintain efficiencies in your operations and stay competitive. Any business that doesn’t have a plan for replacing outdated equipment will find itself penalized by potential buyers. Keeping your infrastructure up to date also places your company in a position to handle future growth.

Risk is abundant in any business venture. Managing risk is on-going process. Too often, risk management is often performed by small business owners after the fact. A pro-active approach to identifying external and internal risks to your operations keeps you one step ahead of your competition. The risk assessment process identifies areas where the risk of the dollar value of loss and the probability of loss is above your defined threshold. Some risks are transferred to third parties, for example, by the purchase of insurance policies. Other risks can be addressed by strengthening internal controls, instituting formal policies and procedures, and creating a contingency plan.

Conclusion

Maximizing the value of the sale of your business is an ongoing process that doesn’t happen overnight. A structured approach focuses on the attributes that potential buyers can identify and quantify. Your actions now can pay big dividends when the time is right.

Please contact me for additional information.


John M. Byrne, CPA/ABV
Mallah Furman, Certified Public Accountants
954-475-3199