In Summary
- To establish the most accurate EBITDA (the primary valuation metric for middle-market companies), owner compensation—including salary, benefits, and discretionary expenses—must be adjusted (“normalized”) to reflect a market-rate salary for the owner’s role; failure to do so can artificially inflate or deflate reported profits.
- Owners should begin normalizing compensation and removing personal expenses one to two years before a sale to embed the impact into historical financials, and they should delegate key responsibilities to a management team to demonstrate operational independence, thereby reducing perceived risk and streamlining the due diligence process.
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When preparing to sell a Denver middle-market company, one aspect that often gets overlooked is the business owner’s compensation. However, compensation plays an important role in determining the company’s value, impacting everything from financial transparency to buyer confidence. Understanding how compensation affects the sale process is vital for business owners who want to maximize valuation amount and simplify negotiations. To help clients, prospects, and others, Hanson & Co has summarized the key details below.
Understanding Middle-Market Sales
Middle-market companies, typically defined as those with annual revenues between $10 million and $1 billion, are often referred to as the backbone of the economy. These businesses attract buyers such as private equity firms, strategic acquirers, and family offices, all of whom focus heavily on financial performance when evaluating potential purchases.
Valuation for middle-market companies often hinges on EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA serves as a benchmark for profitability and helps buyers assess the company’s earning potential. Owner compensation, particularly when it deviates from market standards, can distort EBITDA and complicate the valuation process. For buyers, understanding how compensation aligns with market norms is key to assessing whether reported profits accurately reflect the business’s performance.
How Does Owner Compensation Impact Business Valuation?
Owner compensation affects valuation in several ways, particularly through its relationship with EBITDA. Buyers typically analyze whether compensation practices align with market standards, adjusting EBITDA as necessary to reflect these findings. These adjustments can have a significant impact on the company’s perceived value in many ways, including:
- Overcompensation — When owners pay themselves more than what a comparable role in the industry would warrant, it reduces reported profits. For example, if an owner’s salary exceeds market norms by $200,000 annually, buyers may “add back” that amount to normalize EBITDA. While this adjustment can increase the company’s value, excessive compensation might signal inefficiencies or raise questions about the sustainability of profits.
- Under Compensation — Conversely, owners who underpay themselves artificially inflate EBITDA. Buyers will adjust financials downward to account for the cost of hiring someone to fulfill the owner’s role at a market-rate salary. For example, if the owner’s salary is $50,000 below industry standards, the adjusted EBITDA may reflect a lower profit margin, which could reduce the valuation.
- Discretionary Spending — Many business owners include personal expenses, such as travel, vehicles, or family salaries, in the company’s financials. These discretionary expenses are typically normalized during due diligence, but excessive discretionary spending can raise concerns. Buyers may question whether financial statements accurately reflect the company’s profitability.
- Normalizing Compensation – This type of compensation involves adjusting the owner’s salary and benefits to align with market standards. This process ensures that financial statements accurately represent the company’s profitability, making it easier for buyers to evaluate the business.
- Setting a Market-Based Salary — One of the first steps in normalization is benchmarking the owner’s compensation against similar roles in the industry. Factors such as company size, revenue, and the owner’s responsibilities should guide this adjustment. Aligning the salary with market rates helps buyers see the company’s financial situation as sustainable and credible.
- Removing Discretionary Expenses — Personal expenses included in the company’s financials should be reduced or eliminated. These expenses can distort profitability and complicate the valuation process. Documenting and justifying these changes demonstrate transparency to buyers.
- Timing Adjustments — Compensation adjustments should begin at least one to two years before listing the company for sale. This allows the financial impact of normalization to appear in historical financial statements, giving buyers a clearer picture of the business’s long-term performance.
- Operational Independence – A company’s value is often tied to how dependent it is on the owner. Buyers will evaluate whether the owner’s compensation aligns with the level of involvement in daily operations. If the owner is heavily involved and draws a high salary, buyers may perceive this as a risk, as replacing the owner could require hiring multiple roles or restructuring operations.
- Delegation and Scalability — To reduce perceived risks, owners should focus on delegating key responsibilities to a management team. By creating a scalable business model, owners can demonstrate that the company can operate successfully without direct involvement. Aligning compensation with market standards further reinforces this point.
- Transition Planning — Buyers often look for companies with clear succession plans. Transitioning responsibilities to other team members and documenting these processes can help ease buyer concerns about operational continuity. A well-documented transition plan, coupled with market-aligned compensation, shows that the business is prepared for a change in ownership.
- Preparing for Due Diligence — During the due diligence process, buyers will closely review compensation practices to assess the company’s profitability and sustainability. Business owners should prepare for this scrutiny by documenting all compensation adjustments and providing clear explanations.
- Documenting Adjustments — Every change made to normalizing compensation should be supported by detailed records. This includes explaining the rationale behind adjustments, such as aligning with industry benchmarks or removing discretionary expenses. Providing this documentation upfront can reduce buyer concerns and streamline negotiations.
- Seeking Professional Guidance — Working with a CPA or financial advisor is invaluable when preparing for due diligence. These professionals can help ensure that compensation adjustments are appropriate, well-documented, and aligned with market standards. They can also assist in presenting financials in a way that instills buyer confidence.
Contact Us
For business owners preparing to sell, consulting with qualified professionals is an important step in preparing the company for sale. This includes the optimization of compensation practices. A knowledgeable advisor can guide the normalization process, ensuring financials accurately reflect value. If you have questions about the role of owner compensation or need assistance with a business valuation, Hanson & Co can help. For additional information call 303-388-1010 or click here to contact us. We look forward to speaking with you soon.