United States: (Un)Reasonable Compensation – An Easy Way To Manipulate Value In A Business Valuation

Last Updated: January 28 2014
Article by Eric S. Solotoff

We deal with a fair number of cases where a spouse's interest in a business has to be valued for equitable distribution purposes.   While there are many objective parts of a business valuation report, reasonable (a/k/a replacement) compensation is subjective.   That is why this is one of the first things I look at when partisan experts issue widely varying values.  Even when reviewing a joint or neutral report, or when the values are reasonably close, I will often go right to the reasonable compensation to see if it appears to make sense.

What is reasonable compensation?  In noted valuation expert Shannon Pratt's book, The Lawyer's Business Valuation Handbook", he defines it simply as "What would it cost the company for a hypothetical replacement for the position in question."  He further notes that the principle is substitution, not on whether the specific person is worth more or less.  Pratt notes that when determining reasonable compensation, the expert must quantify the total compensation being paid to the party in question and compare that to the compensation needed to attract an employee or employees of similar skill.

Why is it important?  Because the higher the reasonable compensation, the lower the value of the business and vice versa.  As such, when there are partisan experts, it is not unusual for these subjective factors to favor the party that the expert is working for.  That said, depending on the industry, there are numerous publications and databases that the experts use to determine reasonable compensation – so one would think that this subjective factor might be closer.  That happens sometimes, but not always.

For divorce purposes, as well as many other situations where businesses are valued, they are valued based in whole or part on their income.  Reasonable compensation is a consideration in two valuation methods often seen in divorce cases – the excess earnings method and the capitalization of earnings method.  These methods involve examining earnings available to a potential hypothetical buyer after he or she receives a "reasonably compensation"  for running the business. Earnings available, beyond "reasonable compensation" are a large factor in valuation. The higher this figure is, the more the business may be worth. In the excess earnings method, the difference between actual compensation and reasonable compensation is capitalized and for all intents are purposes represents the "intangible asset" known as good will of the business.

In cases where there are publications and databases, such as physicians or laywers, for example, one would expect to see the experts using the data sources, but selecting income information from different percentiles, etc. That said, I just had a matter where the experts differed by nearly $600,000 on reasonable compensation of a doctor causing their values to be about $1.5 million, or more apart.  In that case, a forensic accountant was brought in to mediate and his opinion was far closer to one party than the other – ultimately getting the people closer to settlement.

In another case, an expert imputed two full time high management level incomes to father and son, where (1) dad worked part time; (2) son just came into to business and was learning the ropes; and (3) there had never been two people in those roles before.  The result was a lowering the value.

In another case, the husband was the sole partner of a law firm that had a few associates.  While the firm was extremely profitable for its size, much of the profits were based upon leveraging associates, as the owner's actual billable hours were pretty small compared to the "average" lawyer.  Because there was no office manager, his expert used reasonable compensation for a lawyer (without adjusting for the fact that this lawyer billed less hours than the peer group that he was being compared to) plus reasonable compensation for an office manager.  The net result of this was substantially lowering the value of his practice.  After a trial, the judge did not buy this and accepted the valuation of our experts who were much more conservative.

In another matter, the opposing expert used a similar figure that our expert used.  However, though he used a five year model, he kept the compensation fixed for each of the 5 years, which is not only unrealistic, it is contrary to economic reality.  As such, it skewed his value in favor of his client's position.

In yet another matter, the client was a brand new partner at one of the top handful of law firms in the country.  Compensation at that firm was significantly higher than even most big firms and non equity partners were making almost seven figures.  The client himself got a seven figure offer to go in house.  That said, the expert used "reasonable compensation" that was more than $750,000 less than he actually earned.  Needless to say, that skewed value in an unreasonable way and was disregarded.

It is important to understand the concept of reasonable compensation, question the experts about their assumptions and data sources used, to make sure that the "reasonable compensation" used in your valuation is not unreasonable.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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