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.

The firm’s financial statement should clearly demarcate direct expenses and indirect or overhead expenses. Direct expenses include all professional staff compensation, including fair market compensation to owners who are advisors. Subtracting direct expenses from revenue indicates gross profit. Negative variations in gross profit margin tell you whether you have a problem with pricing, productivity, service or product mix and client mix. Advisory firms must generate enough gross profit dollars to cover their overhead expenses and produce a net profit.

Net profit (in all its variations including EBITDA, free cash flow, etc.), is the numerator for all return on investment calculations. When the number is larded with compensation to the owner, the Return on Investment (ROI) and Return on Sales (ROS) are always inflated. Many advisory firms actually are generating close to no profit at all once an adjustment is made for fair compensation for the owner. In that case, it does not have enterprise value. Rather, it has liquidation value.

If a firm’s net profit margin is declining or below the benchmark, this indicates a revenue growth problem or an expense control problem. Each of these data points reveals symptoms and potential solutions for underperforming components.

Owners often handle managerial functions within the firm as well as serving as advisors. For accounting purposes, their fair market compensation should be allocated between the time they spend in an advisory role and the time they spend in an administrative role. This may be a “guesstimate” but most advisors are aware of where they spend time each day. If not, this bit of accounting discipline in tracking time should clarify where they are most effective and how their time impacts the firm.

So, what is fair compensation? This question challenges many advisory practices. Some advisors still struggle to find the right benchmarks, especially when they believe their firm is unique and incomparable to others. Several excellent studies are available to help, all based on the original work started by Moss Adams in the 1990s. Investment News took over the Moss Adams research on financial performance, compensation and staffing ­several years ago to provide a consistent source of data for the financial advisory business. They remain the leading reference for firms attempting to analyze their own operating performance and costs. (http://research.investmentnews.com/dashboard/studies).

While it may be difficult to find an exact comparable, the data provides a frame of reference when making critical management decisions. Some advisory businesses may choose to use their own best year as a benchmark, or some aspirational goal, but the study detail provides valuable insight into which indicators are important.

As the business of financial advice matures — becoming more refined and similar to other professions — it is important to use the same discipline and process for assessing business performance and valuations.

The key is to differentiate the reward for labor vs the reward for ownership. For business management and merger & acquisition purposes, all parties need to understand the allocation between labor costs and return on sales (e.g. profits) in order to appreciate the true financial condition of the business.

Mark Tibergien is CEO of BNY Mellon’s Pershing Advisor Solutions. Tibergien is also the author most recently of “The Enduring Advisory Firm,” written with Kim Dellarocca of BNY Mellon and published by Wiley. He can be reached at mtibergien@pershing.com.