Valuing the Closely Held Business

Many closely held businesses and professional practices distribute most, if not all, of their earnings to the owner(s) and do not make the distinction between what constitutes fair and reasonable compensation for services that the owner provides to the entity versus what constitutes a return on the ownership interest. It is, therefore, the job of the valuator to separate the earnings stream into those two components.

An owner's compensation may consist of many segments. The most obvious elements are the base salary, bonus, dividends and/or withdrawals that the business pays to its owner. There are also other discretionary items that are many times commonplace in closely held businesses and professional practices and may, in fact, be considered compensation. The valuation process not only involves identifying the obvious elements of the earnings stream, but also includes an analysis that goes beyond the numbers as reported to determine if there are any perquisites, personal expenses or other items. These may be disguised in such business expense categories as entertainment and automobile expenses that are reported on the subject entity's books but are, in essence, part of the 'compensation package.' An owner's 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 as a greater benefit or to the exclusion of other non-owner employees of the business. Entertainment expenses may be, in reality, 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.

Another, less recognized area where replacement compensation should be considered is compensation paid to related parties (i.e., family members). It is certainly not improper to include a family member on the company's payroll as long as the compensation is reasonable and the services for which payment is made are actually performed. In such instances, however, it may be necessary to substitute the compensation that is actually paid to the 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.

Why Is Replacement Compensation Important?

Considering that, in many cases, the adjustment for replacement compensation is one of the largest monetary adjustments made during the valuation of a small- to medium-sized operating entity, it should be undertaken with utmost care and consideration.

The theoretical underpinnings of valuing an ownership interest assume that there is some value attributable to the economic benefits afforded the owner (i.e., the prerogatives of ownership including the power to determine management compensation and perquisites) that is not present in a mere employer/employee relationship. The excess of earnings over and above what the individual would earn absent the ownership interest, i.e., replacement compensation as a non-owner, forms the basis for the goodwill connected to the ownership interest. Non-owner replacement compensation is, therefore, a critical component in a valuation. It is the job of the valuator to break down the net income into its two distinct components. The first component is the compensation to the owner and related parties without regard to the prerogatives afforded to an ownership interest. The second component represents the remaining amount of income attributable to the ownership interest itself. By adding back the actual compensation paid to the owner and other related parties and subtracting a provision for non-owner or fair market replacement compensation from the earnings stream being capitalized, the valuator has essentially isolated or captured that portion of the earnings stream attributable to 'ownership,' which is the subject of valuation.

Issues to Identify and Avoid

During the valuation process, the valuator must be careful to identify the components of compensation that will be replaced, and ascertain if the same elements are included in the level of replacement compensation being substituted. Failure to do so may create a double counting that could distort the earnings that are ultimately used as a basis for valuation. For example, some compensation surveys that are referenced as evidence of replacement compensation present their data as 'total compensation,' which, in some instances, includes base salary and perquisites. If the valuator does not include the owner's perquisites as an add-back to the earnings stream before subtracting a level of replacement compensation based on a 'total compensation' that includes perquisites, he/she has misstated the normalized earnings stream that forms the basis for valuation. Depending on the level of perquisites that were ignored, the resulting aberrational value could be significantly higher or lower than it actually should be.

There are also other forms of double counting (duplication) that must be considered in the equitable distribution of an ownership interest vis-'-vis spousal maintenance in matrimonial proceedings. In its decision in McSparron v. McSparron (87 NY2d 275, 662 (1995), the New York Court of Appeals referenced the license/ practice/maintenance overlap when it concluded that professional licenses may have an ongoing independent vitality and, as such, should be valued in a way that avoids duplicative awards. The court stated, 'Care must be taken to ensure that the monetary value assigned to the license does not overlap with the value assigned to other marital assets that are derived from the license such as the licensed spouse's professional practice.'

When both a professional practice and a professional degree or license are being valued, replacement compensation becomes a key factor in both valuations. In such instances, duplicative awards are avoided by utilizing the level of non-owner replacement compensation assigned in the practice valuation as the Top-Line Earnings (i.e., the license holder's earnings capacity with the attainment) in the license computation.

In cases where a business or practice interest is valued without the valuation of a professional degree or license, it is also necessary to guard against potential duplication in the form of maintenance derived from earnings that are incorporated in the asset value, assuming equitable distribution of that asset. This is achieved by limiting the income available for maintenance to the level of non-owner replacement compensation assigned for the services rendered by the owner to the entity being valued. Since the income in excess of the replacement compensation is incorporated into the value of the asset, it is only the replacement compensation that is available for maintenance and child support.

The duplication concept, however, was most recently argued before the Court of Appeals in the case of Keane v. Keane, 8 NY3d 115 (Dec. 21, 2006). Also, in Holterman v. Holterman 3 NY2d 1 (Jun 10, 2004), a case in which this author's firm was retained as valuation experts, the Court of Appeals ruled on the issue of duplicative awards in the context of child support. In both instances, the court created a dangerous and troublesome precedent that could result in serious unintended consequences.

Johanne M. Floser is a Certified Business Appraiser (CBA) and Manager with BST Valuation & Litigation Advisors, LLC, with offices in Albany, NY, and New York City. She has extensive experience in the valuation of privately held business enterprises, professional practices, professional licenses, advanced academic degrees and pension/retirement plans for use in matrimonial matters, litigation, buy/sell transactions, estate tax proceedings and other circumstances.

Aside from the many important and critical issues involving children and family, the valuation of a closely held business or professional practice may be one of the most significant issues a practitioner will face when resolving the financial aspects of matrimonial matters. In that regard, one of the most important aspects that the valuator is confronted with is the establishment of a reasonable level of replacement compensation to assign to the owner in the valuation of an ownership interest.

In order to do this properly, one must be aware of various concepts relating to replacement compensation, including: 1) what it is; 2) why it is important; 3) what issues must be identified and avoided; and 4) how replacement compensation is determined. Even though you may be counting on experts to value these assets, an understanding of what they are (or should be) considering in their thought processes is a valuable tool.

What Is Replacement Compensation?

Many closely held businesses and professional practices distribute most, if not all, of their earnings to the owner(s) and do not make the distinction between what constitutes fair and reasonable compensation for services that the owner provides to the entity versus what constitutes a return on the ownership interest. It is, therefore, the job of the valuator to separate the earnings stream into those two components.

An owner's compensation may consist of many segments. The most obvious elements are the base salary, bonus, dividends and/or withdrawals that the business pays to its owner. There are also other discretionary items that are many times commonplace in closely held businesses and professional practices and may, in fact, be considered compensation. The valuation process not only involves identifying the obvious elements of the earnings stream, but also includes an analysis that goes beyond the numbers as reported to determine if there are any perquisites, personal expenses or other items. These may be disguised in such business expense categories as entertainment and automobile expenses that are reported on the subject entity's books but are, in essence, part of the 'compensation package.' An owner's 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 as a greater benefit or to the exclusion of other non-owner employees of the business. Entertainment expenses may be, in reality, 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.

Another, less recognized area where replacement compensation should be considered is compensation paid to related parties (i.e., family members). It is certainly not improper to include a family member on the company's payroll as long as the compensation is reasonable and the services for which payment is made are actually performed. In such instances, however, it may be necessary to substitute the compensation that is actually paid to the 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.

Why Is Replacement Compensation Important?

Considering that, in many cases, the adjustment for replacement compensation is one of the largest monetary adjustments made during the valuation of a small- to medium-sized operating entity, it should be undertaken with utmost care and consideration.

The theoretical underpinnings of valuing an ownership interest assume that there is some value attributable to the economic benefits afforded the owner (i.e., the prerogatives of ownership including the power to determine management compensation and perquisites) that is not present in a mere employer/employee relationship. The excess of earnings over and above what the individual would earn absent the ownership interest, i.e., replacement compensation as a non-owner, forms the basis for the goodwill connected to the ownership interest. Non-owner replacement compensation is, therefore, a critical component in a valuation. It is the job of the valuator to break down the net income into its two distinct components. The first component is the compensation to the owner and related parties without regard to the prerogatives afforded to an ownership interest. The second component represents the remaining amount of income attributable to the ownership interest itself. By adding back the actual compensation paid to the owner and other related parties and subtracting a provision for non-owner or fair market replacement compensation from the earnings stream being capitalized, the valuator has essentially isolated or captured that portion of the earnings stream attributable to 'ownership,' which is the subject of valuation.

Issues to Identify and Avoid

During the valuation process, the valuator must be careful to identify the components of compensation that will be replaced, and ascertain if the same elements are included in the level of replacement compensation being substituted. Failure to do so may create a double counting that could distort the earnings that are ultimately used as a basis for valuation. For example, some compensation surveys that are referenced as evidence of replacement compensation present their data as 'total compensation,' which, in some instances, includes base salary and perquisites. If the valuator does not include the owner's perquisites as an add-back to the earnings stream before subtracting a level of replacement compensation based on a 'total compensation' that includes perquisites, he/she has misstated the normalized earnings stream that forms the basis for valuation. Depending on the level of perquisites that were ignored, the resulting aberrational value could be significantly higher or lower than it actually should be.

There are also other forms of double counting (duplication) that must be considered in the equitable distribution of an ownership interest vis-'-vis spousal maintenance in matrimonial proceedings. In its decision in McSparron v. McSparron (87 NY2d 275, 662 (1995), the New York Court of Appeals referenced the license/ practice/maintenance overlap when it concluded that professional licenses may have an ongoing independent vitality and, as such, should be valued in a way that avoids duplicative awards. The court stated, 'Care must be taken to ensure that the monetary value assigned to the license does not overlap with the value assigned to other marital assets that are derived from the license such as the licensed spouse's professional practice.'

When both a professional practice and a professional degree or license are being valued, replacement compensation becomes a key factor in both valuations. In such instances, duplicative awards are avoided by utilizing the level of non-owner replacement compensation assigned in the practice valuation as the Top-Line Earnings (i.e., the license holder's earnings capacity with the attainment) in the license computation.

In cases where a business or practice interest is valued without the valuation of a professional degree or license, it is also necessary to guard against potential duplication in the form of maintenance derived from earnings that are incorporated in the asset value, assuming equitable distribution of that asset. This is achieved by limiting the income available for maintenance to the level of non-owner replacement compensation assigned for the services rendered by the owner to the entity being valued. Since the income in excess of the replacement compensation is incorporated into the value of the asset, it is only the replacement compensation that is available for maintenance and child support.

The duplication concept, however, was most recently argued before the Court of Appeals in the case of Keane v. Keane , 8 NY3d 115 (Dec. 21, 2006). Also, in Holterman v. Holterman 3 NY2d 1 (Jun 10, 2004), a case in which this author's firm was retained as valuation experts, the Court of Appeals ruled on the issue of duplicative awards in the context of child support. In both instances, the court created a dangerous and troublesome precedent that could result in serious unintended consequences.

Johanne M. Floser is a Certified Business Appraiser (CBA) and Manager with BST Valuation & Litigation Advisors, LLC, with offices in Albany, NY, and New York City. She has extensive experience in the valuation of privately held business enterprises, professional practices, professional licenses, advanced academic degrees and pension/retirement plans for use in matrimonial matters, litigation, buy/sell transactions, estate tax proceedings and other circumstances.