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How Do I Handle Officer Compensation When There Are Multiple Owners?

Treatment of Owner Compensation Entry

When addressing the owner compensation line entry, note that there are different situations which may arise involving the following factors:

Owner Compensation Entry is Affected By.........

a) the number of owners

b) active or passive/absentee owners

c) owners who are paid or not paid


Here is the relevant discussion pertaining to the different scenarios which will arise:


In EVERY case, you want to include ALL of the compensation (salary/payroll tax/benefits) that was ACTUALLY paid to the primary owner-operator (if there are two, one must be considered the "primary" owner).


When there is a second (or third or fourth) owner who is working in the business and being compensated, you must COMPARE the actual total compensation paid to this second owner (deducted salary/payroll tax/benefits) with the probable REPLACEMENT COST by a new owner (who replaces the primary owner but must hire someone to do the work of the second owner) based on current market compensation levels.


2nd Owner Paid LESS than Replacement Cost

For example, assume that the second owner is paid $100K in salary, $7K in payroll taxes and $23K in benefits (total compensation is $130K) but the new (hypothetical) buyer must pay a total compensation package of $200K to replace the work contribution of the second owner - this means that the owner compensation line entry must be REDUCED by $70K (Replacement cost of $200K less Actual cost of $130K equals $70K).  This reflects the fact that the new owner will need to pay $70K more than what the second owner has been paid in order to receive the same level/quality of work contribution.


2nd Owner Paid MORE than Replacement Cost

If the figures were reverse, i.e. if the ACTUAL compensation was $200K and the REPLACEMENT compensation was $130K, then the differential of $70K must be ADDED to the owner compensation line entry.  This reflects the fact that the new owner will be paying $70K less in total compensation after replacing the second owner at market wages for same level/quality of work contribution.


These adjustments serve to alter the amount of "discretionary earnings" available to the incoming, hypothetical buyer under the fair market value standard of value, which in turn affects the estimated fair market value.  Higher discretionary earnings, higher asset sale value - and then higher equity and enterprise value.


Adjustments Can Also Be Handled in "One-Time/Non-Operating" Line Items

Note that these adjustments of $70K (plus or minus) could also be handled in the "One-Time/Non-Operating" line items.  


In the first scenario (ACTUAL less than REPLACEMENT), the $70K would be entered as a "One-Time/Non-Operating REVENUE" amount.  This serves to decrease the discretionary earnings available to a hypothetical buyer replacing the current primary owner.


Under the second scenario (ACTUAL greater than REPLACEMENT), the $70K would be entered as a "One-Time/Non-Operating" EXPENSE amount.  This serves to increase the discretionary earnings available to a hypothetical buyer replacing the current primary owner.


Situations Involving Passive/Absentee Owners

In the case of a single owner who is "absentee", it will be necessary to include the ACTUAL total compensation paid to the top manager of the firm.  The logic here is that the hypothetical buyer of the business will replace the work efforts of the top manager and actively run the business.


In the case of two owners with one active and paid owner and the second owner "passive" (absentee) but being paid compensation, ALL of the ACTUAL compensation paid to this passive owner should be included in the owner compensation line entry (along with the primary owner compensation).  This is due to the fact that the incoming hypothetical buyer will have access to these payments (cash flows) and they are therefore part of the firm's "discretionary earnings".


If there are two or more absentee owners, ALL of their ACTUAL compensation should be included in the owner compensation line for the same reasons as discussed above.

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