This article are provided for information purposes only, and are not intended as legal advice.


Valuation of a business

December 11th, 2008

If you sales are dropping and costs or rising, owners unfortunately will end up having to reduce or eliminate their salary.  Fluctuating the owners’s salary should have no impact on the valuation on the sale of  a business.   Most investors will look at normalized earnings to value a business. Normalized earnings are usually calculated backwards, starting with the net income reported on the financial statements.  Add back all personal expenses and I typically add back the owners salary.  Then I reflect a salary for what you would have to pay to replace that owner.  if the owner is taking only $20,000 in salary but you determine that you would have to pay say $65,000 for an independent person to replace the owner, then you would reduce normalized earnings by $45,000.  If there were no other adjustments except for the salary adjustment, you would drop the reported income by $45,000 in my example above ($65,000 which you consider normal less $20,000 actually takend out by the owner).  Conversely, if the owner took out $200,000 and you could replace the owner with a person making $65,000, then the excess amount or $135,000 really relates to being an owner and return of capital rather than a salary.  In this case, you would increase normalized earnings by $135,000.

In the economy is changing over the next few months, many owners may get fooled and think that you do not reflect any salary for the owner in the calculation of goodwill.  This is incorrect.  Owner compensation is made up of two distinct items, salary for working 40, 50 or more hours per week and compensation for person for being the shareholder of the business.  Normalized earnings should always reflect a reasonable salary for an owner if they are active in the business. The salary adjustment calculation should be reflected in normalized earnings in my opinion even if the owner did not draw a salary during the year.


Filed under: Buy a business,valuation of a business — Gary Landa @ 9:56 am


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