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Owner Compensation and Company Valuation

As you know, Service Leadership’s primary mission is to help you build equity through increased cash flow, enhanced strategy and reduced risk. Generally, how cash flow is determined usually plays greatly in the determination of equity value.

On an income statement, cash flow is most closely approximated by Adjusted EBITDA. As of Q4 last year, we updated the Normalized Solution Provider Chart of Accounts (NSPCoA) to include some new features. One of them is an Adjusted EBITDA line where we normalize profits for various owners’ compensation strategies, as we do in our broader benchmark population.

Now we’d like to provide some insight into how owners’ compensation is generally treated when determining Adjusted EBITDA.

How owners pay themselves varies greatly based on a multitude of factors including personal preference, tax strategy, type of corporation, partnership arrangements, and so on. For purposes of discussing the most common scenarios, we will address this document to private (non-public) companies who are filed as Subchapter S (“S-corps”) and various forms of limited liability concerns. This means we are leaving out “C-corps” for simplicity, since the majority of Solution Providers are not C-corps or public companies.

Caution: Service Leadership is not a tax advisor and we are not giving tax or accounting recommendations here. We are simply discussing how owners’ compensation is often treated during valuations. Please do not change your tax strategy based on what you read here first without consulting with your tax professional.

The issue of determining Adjusted EBITDA is important because a common method of valuation is to apply a multiple to the Adjusted EBITDA. Thus if Adjusted EBITDA is $250,000 and the current market multiple is, say, 4.0, then the valuation discussion will start at 4.0 x $250,000 or $1,000,000. Every dollar of Adjusted EBITDA up or down from $250,000 will thus influence the outcome by four times as much. As a result there is often a great deal of inspection and back-and-forth between the parties as to how much is Adjusted EBITDA.

In small companies, Adjusted EBITDA is often subject to large swings based on both how, and how much, the owner is compensated. (In fact, you could almost define “small company” as one in which the owners’ compensation does equate to a large portion of EBITDA.)

Four Too-Inexpensive Executives

Keeping in mind we are not talking about C-corps, we can categorize the three most common strategies for owners’ compensation just as Goldilocks might do: 1) Too Much, 2) Too Little and 3) Just Right.

We’ll get into the details in a moment, but your first question should be: “Too much or too little as compared to what?”

Good question. As we will see, when we normal normalize owners’ compensation, we set it at what we call Fair Market Compensation for Same Position (FMCfSP). From our Service Leadership Index® annual compensation benchmark, our various financial benchmarks and the hundreds of income statements that we decode each year in our consulting practice, we have a pretty good idea of what compensation the market requires to hire a non-owner executive of suitable capability to fill the given role (CEO, COO, VP of Sales or Service, etc.).

Why do we replace owners’ compensation with Fair Market Compensation for Same Position when we calculate Adjusted EBITDA? Several reasons combined:

  1. We have to set it at something.
  2. The cost to hire a non-owner executive eliminates equity as a reward for performance, and eliminates (most) risk that is offset by equity.

To give an idea of how this can impact the discussion, we’ll share an example we encountered several years ago. The party shall remain nameless though this was not an M&A transaction.

An $11 million Solution Provider in one of the three largest U.S. metro areas, was owned by four equal partners, who were also employed in the company as CEO, CFO, EVP of Sales and CIO (really, services executive), each with equal shares and, as it turned out, equal “pay”.

We were hired to help them architect and roll out a successful Managed Services practice. As we always do, we decoded their income statement in order to determine if their current services were indeed profitable (if not, some things needed to be fixed first to avoid rolling out an unprofitable Managed Services practice) and if the company was indeed profitable (if not, some things needed to be fixed before they can afford to invest in Managed Services).

Here’s what we found. The company was about 70% service and 30% product. Their income statement showed a 21.3% EBITDA. This is very high for this revenue mix; Best-in-Class at the time for their Predominant Business Model (PBM) of Infra – Technical Services was 14.9%. Our initial eyeball and “sniff-test” had indicated to us that the company was probably well-run, and it is possible to have an $11mm Infra-Technical Services company run at 21% EBITDA, but it is not common even among Best-in-Class.

What was at stake here was their ability to fund an aggressive Managed Services roll-out in a major market. In addition, their actual profit attainment compared to Best-in-Class would help us understand how skilled they were as managers and leaders, which in turn would help guide us as to the types of help they would need from us, the degree to which we would advise they should be aggressive, and what risk mitigations steps we would suggest.

While gross margins were good, what jumped up immediately was low Sales, General and Administrative (SG&A) cost. Given that management pay is normally a large portion of this in any small company, this is where we started our questions.

S-L: “What do you pay yourselves?”

Client: “Each of us gets paid $90,000 a year.”

S-L (knowing of the notoriously high cost of living in this market): “Why so low?”

Client: “We don’t think that’s low.”

S-L: “Let’s compare to an objective measure. What would you have to pay four em executives who were qualified, to come in and do your jobs?”

Client: “$90,000 each.”

At that time in that market, a decent Cisco CCIE could earn $175,000 a year.

In relatively short order, they said they liked to talk about being highly profitable, among themselves and among their social peers, and that they felt such a profile would over time attract a buyer with a favorable valuation. It was simply their preferred way of looking at themselves.

Fair enough, unless they started to believe their own story, which would likely degrade their management ability and deliver an unfortunate surprise when a valuation from an experienced party was received. In addition, to have a realistic conversation with them about Managed Services strategy and risk, it would be better if we reached agreement on what were the company’s true cash resources.

Here was their income statement prior to our discussion:

Revenue ($mm) $ 11.00
Gross Profit $ 4.78
SG&A $ 2.45
Net Income $ 2.33
ITDA Add-Back $ 0.03
EBITDA $ $ 2.36
EBITDA %   21.4%

As we continued the discussion, the CFO informed us that the four executives took distributions at the end of each year, which significantly boosted their actual income. Some years were better than others, and the distribution varied a bit, but over time the total of their salary and typical distribution had hovered around $300,000 each.

We proposed to them that to hire executives qualified to do their jobs, they would have to pay about $250,000 annually for each. In fact, the market pay for such skills was probably closer to $300,000, but we did not need precision in this case. Thus, SG&A would increase by the difference between their “salaries” and their FMCfSP or 4 x ($250,000 - $90,000) = $640,000. They agreed, and we added that amount to their SG&A, re-stated their performance as follows:

Revenue ($mm) $ 11.00
Gross Profit $ 4.78
SG&A $ 2.45
Net Income $ 2.33
ITDA Add-Back $ 0.03
EBITDA $ $ 2.36
EBITDA %   21.4%
Adjustment to SG&A for FMCfSP   -0.64
Adjusted EBITDA $ 1.72
Adjusted EBITDA %   15.6%

Based on this, they had still exceeded the Best-in-Class threshold by 0.7%, which is very good performance.

Now we all agreed on how much cash the company was actually generating, which was important to firmly grounding the Managed Services investment, risk and ROI balancing act. We as advisors also had a better idea of the skills and capabilities of the management team; that is, very good but perhaps not yet superstar. This helped us craft the most appropriate strategy, tactics and advice.

There are additional powerful benefits to setting owners’ compensation to FMCfSP: it provides a way to evaluate the owner’s performance as an executive, and to fairly reward owners for their risk as shareholders.

For example, these four owners could now assess themselves as a management team and ask: “Are we performing as well or better than executives we could hire for the same (fair market) pay?” This is often helpful in setting improvement goals and in paying fairly for results attained.

In addition, it indicated to them – now wearing their shareholders’ hats – that each was getting a dividend of about $50,000 a year (total pay of about $300,000 minus FMCfSP of $250,000 equates to a dividend of about $50,000) in return for their equity interest. Was this a good return for the risk? Now they could fairly evaluate their investment in comparison to other investments they might make.

For this company and many others, adjusting owners’ compensation to FMCfSP added clarity and fairness to their decisions both as executives and as owners.

In other cases, owners may take unusually high salary compensation, with similar distorting effects.

Again, there may be tax strategies which make the paying of non-FMPsFP compensation the best strategy. However, our mission here is to evaluate actual performance, for the purpose of improving the company’s cash flow and equity value. Thus, regardless of the tax strategy, we advise performing the adjustments demonstrated in the case above to arrive at a fair assessment of financial and operational performance.

Neutralizing the Goldilocks Effect

This now leads us, to how Service Leadership handles the normalization of owners’ compensation.

To understand the importance of this in benchmarking, let’s look at three Solution Providers who are otherwise identical except for their owners’ compensation strategies.

All three companies have $2mm in revenue and $1mm in COGS, yielding $1mm in gross margin. All three companies report $750,000 in expenses (SG&A) and therefore an EBITDA of $250,000 or 12.5%. But are they really performing the same? Which has more financial safety? Which has more resources to invest? Which management team is more effective?

The answers can be found if we normalize owner compensation. Let’s say that Fair Market Compensation for Same Position (FMCsSP) for the CEO position is $200,000.

In Company 1, the owner is paying him/herself $150,000, which results in over-stating financial performance by $50,000 or 2.5% of EBITDA.

Co. 1: Owners Pay Themselves Too Little
Income Statement (P&L) Revenue $ 2,000,000
Gross Margin $ 1,000,000
Expenses (Incl. Owners' Comp) $ 750,000
EBITDA $ 250,000
EBITDA %   12.5%
     
Owners' Stated Comp $ 150,000
Fair Market Comp $ 200,000
Delta Between the Two $ (50,000)
     
Adjusted EBITDA $ 200,000
Adjusted EBITDA %   10.0%

In Company 1, reported EBITDA performance is 12.5% but when normalized, the company is performing at 10.0%.

In Company 2, the owner is paying him/herself $250,000, which results in under-stating financial performance by 2.5%

Co. 2: Owners Pay Themselves Too Much
Income Statement (P&L) Revenue $ 2,000,000
Gross Margin $ 1,000,000
Expenses (Incl. Owners' Comp) $ 750,000
EBITDA $ 250,000
EBITDA %   12.5%
     
Owners' Stated Comp $ 250,000
Fair Market Comp $ 200,000
Delta Between the Two $ 50,000
     
Adjusted EBITDA $ 300,000
Adjusted EBITDA %   15.0%

Although the two companies show identical unadjusted EBITDAs of 12.5%, in fact, Company 2 is generating 50% more EBITDA dollars than Company 1. This is a substantial difference in ability to make investments and absorb risk, and it may (or may not) be due to differences in management effectiveness.

It is also a substantial difference in valuation. If both companies were valued solely based on their Adjusted EBITDA performance, and the valuation multiple was 4.0, then Company 1 is worth $800,000 and Company 2 is worth $1,200,000. Indeed, it is possible that a buyer might award an extra few tenths of a point on the valuation multiple to the more profitable company, since the higher performance provides the buyer with more comfort (i.e. presumably less risk).

Lastly, we look at Company 3, the “just right” case.

Co. 2: Owners Pay Themselves Just Right
Income Statement (P&L) Revenue $ 2,000,000
Gross Margin $ 1,000,000
Expenses (Incl. Owners' Comp) $ 750,000
EBITDA $ 250,000
EBITDA %   12.5%
     
Owners' Stated Comp $ 200,000
Fair Market Comp $ 200,000
Delta Between the Two $ –
     
Adjusted EBITDA $ 250,000
Adjusted EBITDA %   12.5%

In Company 3, the owner is paying him/herself equal to FMCfSP, and the 12.5% EBITDA performance is in fact correct.

Normalizing owner compensation also helps gauge management’s performance in relation to other executives in the market. In Company 1, before adjustment, an otherwise uninformed observer might conclude the company was getting a great value from the CEO. After all, $150,000 in compensation is returning 12.5% performance, as compared to Company 2 which has to spend $250,000 in compensation to get “the same” performance. However, once we normalize owner compensation to the fair market level, the actual difference in performance becomes clear. In addition, the amount needed to be paid to replace the CEO is known, which may lend a sense of materiality to the discussion.

We should note here that the examples we have given assume that the owners’ salary is being allocated to expenses (SG&A) and not to Cost of Goods Sold (COGS). However, for the purposes of adjusting to arrive at bottom line profit, it does not matter whether owners’ compensation is coded to COGS or to SG&A; what matters is simply that the delta between owners’ compensation and FMCfSP is added to or subtracted from EBITDA.

Ok, Then What’s Fair Market Compensation?

There are six factors in determining the fair market compensation of an owner active in the business. Of these, three are most important:

  1. Revenue size,
  2. Predominant Business Model,
  3. Number of owners.

    4. Three are less important:

  4. Position of owner within company,
  5. Geographic location of company,
  6. Profitability of company.

The ownership share of the owner in question does not matter; this is because we are ascertaining what it would cost to hire a qualified executive who does not have an ownership stake.

When we normalize for benchmarks, to keep things as simple as possible, we normalize based on the first three factors. They have the largest impact on executive (as opposed to owner) compensation and they are the simplest to apply across a large number of benchmark participants. When we normalize for valuation purposes, because of what is usually at stake and because we are dealing with only one company at the time, we also include the three additional factors in our normalization.

Revenue size is a simple substitute for the complexity and responsibility of the executive’s job.

Predominant Business Model© recognizes that even if two Solution Providers are the same revenue size, the complexity and responsibility is not the same, and hence the likely fair market cost of an executive will differ.

For example, let’s take the case of two very different $7mm Solution Providers, one of which is 90% product-resale and one of which is 90% services. Assuming all employees are performing up to plan, the product-centric firm is likely to have about 3 sales people and 5 billable technical people, and a total of perhaps 12 or so people, serving about 140 customers. In contrast, the services-centric firm is likely to have about 7 sales people, some 42 billable technical people and a total of perhaps 55 people, serving fewer customers (perhaps 50) with more complex relationships.

No-one said it was easy running a product-centric firm, but it’s clear that both revenue size and Predominant Business Model© are key factors in determining what one might have to spend to hire a em executive to run the company in question. There are less dramatic but still material differences in fair market executive compensation between other PBMs, as well.

The third important factor is the number of owners in the company. This factor is unlikely to translate cleanly to the number of executives needed to actually run the company. In a large minority of cases, there will be more owners (usually in executive positions) in a company than there would be if one simply determined the number of executives the company actually needed to run. Since few small companies can afford to have more executives than it needs, the end result is that fair market compensation for each owner must drop as the number of owners increases.

A simple example will help make this clear. Let’s say we have a $2mm company with three owners: a CEO, a VP of Sales and a VP of Services. Practically speaking, if there were a single owner who was not running the company, he or she would probably hire a CEO, let the sales people report directly to that person, and hire a director or manager to run the services team. They might have to pay $200,000 a year for the CEO and perhaps $120,000 for the service manager.

This is the “market” solution, and therefore $320,000 represents the “market” executive compensation load for the firm. In this case, for benchmark purposes, we would normalize the pay of the three owner/executives to about $110,000 each (depending on PBM of course), even though the market compensation for each as individuals would probably be somewhat higher. Remember our goal is to fairly compare company performance, and so we have to adjust the executive compensation load to what fair market would be for the company, not for the combined individual owners.

This also – again – promotes healthy thinking about the performance of the owners as executives. If the fair market compensation for three owners in the example company is $320,000 but they are spending, say, $360,000, it will probably occur to the parties in question that they do not need (or at least can’t afford) three executives. The end result may well be that one or two of the owners sell out to the other(s), resulting in better leverage for the remaining owner(s) and probably a more flexible, agile set of strategic alternatives.

Understanding the concepts behind the approach, discussed in this document, will help you plan and execute more effectively to increase shareholder value.