If you work in an advisory firm where you are the owner, should you record your compensation as an expense on your financial statement? We hear this question all the time when buyers and sellers attempt to negotiate the price and terms of a transaction. For tax reasons or a desire for simplistic accounting, advisory firm owners often steer away from paying themselves as employees of the business. Instead, they choose to draw from the profits left after paying all other expenses, including staff compensation. Why is this problematic? It creates an inaccurate reflection of the true cost of doing business when analyzing operating performance. It also obfuscates the business economics when prospective buyers try to determine the firm’s value.
Imagine, for example, that a new buyer must replace a retiring lead advisor who was the previous majority owner. If the seller never recorded her own compensation as an expense, should the new buyer assume that her work with clients will be done for free by the replacing advisor?
Consider the valuation implications. Say an advisory firm generates $5 million of annual revenue, and $1 million of net earnings before owner compensation. If the buyer ignores the cost of replacing the seller as a key employee in the business, and applies a 10x multiple to the bottom line, he would value the company at $10 million. If the buyer adjusts the earnings to reflect fair market compensation to the owner/advisor — let’s say $500,000 a year — that reduces the net earnings to $500,000. A 10x multiple on the adjusted net earnings would produce a $5 million valuation.
It is obvious why the seller would want to omit her compensation as an expense in this example. It is bewildering that the buyer would ignore it as well.
As a starker example, assume that the seller in this case continues working as an advisor in the business for a number of years after the sale. Her responsibilities include managing the most important relationships in the firm and bringing in new clients. Should she expect to be paid for her labor going forward, if her compensation was not counted when determining the purchase price?
On an emotional level, at what point would she grow resentful of the buyer for not paying her fair market compensation as an employee of the business? On a practical level, would it make sense for the buyer to pay a premium to acquire the business, and then pay an ongoing wage to keep her in the firm if this cost was not part of the original calculation? When coming up with an advisory firm value, many owners tend to extrapolate from past performance. Value is a function of the future, however, so all costs — including those related to professional labor — must be included in the final forecast as well as in the historical analysis.
Buying or selling an advisory firm is not the only reason to incorporate compensation for the owner/practitioner in the business. In order to understand how the business is performing as an asset, leaders need to account for all the costs associated with delivering services to their clients, as well as the cost of managing the firm. Surprisingly, even though most owners consider the business their most valuable asset, they often overlook their own investment as an income generator and builder of personal net worth. It is ironic. An advisor who works with other business owners as clients would never be that indifferent as to how the business asset contributes to a client’s wealth (and risk).
Experienced advisors have a discipline around how they project future cash flow, estimate taxes, calculate retirement needs and evaluate investment portfolios for clients. The discipline for evaluating business performance is no different, including the need for accurate accounting of the inflows and the outflows.
In my opinion, owners who work inside their own service businesses must separate their reward for labor and their reward for ownership. These are as different as a bond and a stock.