Establishing the fair value of a business requires a business valuation expert to adjust the revenues and expenses of the business to reflect “normal” operations. Non-recurring and unusual expenses and revenues are eliminated, and recurring expenses and revenues are adjusted to reflect amounts that would be incurred if the owners were “hypothetical” independent investors in the business.
These “normalization” adjustments are not made because the business valuation expert believes anything is wrong with the revenues or expenses but rather that the hypothetical independent investor would not expect the pre-adjusted level of revenues or expenses to occur under his/her stewardship. One important area for “normalizing” expenses is executive compensation.
When business valuation experts analyze executive compensation for potential “normalization” adjustments, they ignore the fact that an executive’s current compensation level may have been adjusted to make up for past underpayments of compensation or that the executive’s current compensation is based on the executive’s past unique or superior contributions to the success of the business.
Instead, business valuation experts generally consider three main issues that can affect the adjustment of executive compensation in business valuations:
- The actual duties and responsibilities of the executive versus the executive’s title;
- The amount of time the executive actually devotes to the business;
- The executive’s compensation (including base salary, bonuses and other cash compensation, non-cash compensation and fringe benefits) versus the “normal” compensation for such a position.
“When it comes to executive titles, I find that some executives hold the title of a much higher position than a title that more closely corresponds to their actual duties, especially in closely held or family businesses,” said David Anderson, principal of David Anderson & Associates, a Philadelphia forensic accounting firm that provides business valuation services in Philadelphia and the Delaware Valley.
“In one family-owned business, a Vice President told me his only responsibilities consisted of (1) reading The Wall Street Journal and certain publications to keep current on issues affecting the company’s industry, and (2) entertaining select customers at golf outings or lunches and dinners,” said Anderson, a forensic accounting expert in Philadelphia who also is a Certified Valuation Analyst.
“In another business, the CEO position was occupied by a figurehead father who only occasionally even visited the business, and whose duties were primarily to “schmooze” with certain long-time customers,” Anderson said. “Meanwhile, his son, a Vice President, was responsible for long-term business strategy and planning, as well as for running the daily operations of the business. In all of these instances, I adjusted the position title of the executive to match that of the actual duties and responsibilities.”
The amount of time an executive actually devotes to the business also is a key element in adjusting executive compensation for a business valuation, explained Anderson, a business valuation expert in Philadelphia whose company offers a full range of forensic accounting services in Philadelphia and the Delaware Valley.
“I had one executive who served as CEO for three separate businesses that had a common ownership,” said Anderson, a Certified Valuation Analyst and forensic accounting expert in Philadelphia. “In valuing each of the three businesses, I extensively interviewed the CEO to determine how much of his time was spent with each business. Based on this, I divided the CEO’s time ratably between the three businesses, even though the CEO’s salary was paid by only one of the three businesses.”
Once the valuator determines each executive’s appropriate position title and percentage of time devoted to the business, the next step is to calculate a “normal” total compensation for each executive, according to Anderson. Two of the widely accepted databases used by valuators for this task are Risk Management Associates and ERI Economic Research Institute, which will be used to collect information about:
- Position title, duties and responsibilities
- Industry
- Geographic location
- Company sales
- Database percentile
Database percentile shows the range of actual compensation data (from 1% to 99%) for the combination of the other factors, explained Anderson, whose company specializes in business valuation services in Philadelphia and the Delaware Valley. Many valuators compare the company’s performance against similar companies in its industry to determine where the company ranks within the 1% to 99% range, and apply that same percentile to the executive compensation, Anderson said. The valuator then adjusts the database-determined compensation for the percentage of time that the executive devotes to the company, he added.
Anderson, a business valuation expert in Philadelphia with expertise in a full range of forensic accounting services in Philadelphia and the Delaware Valley, said the final step in determining the “normalization” adjustment is to compare the calculated compensation for each executive with the actual compensation. The difference between the two becomes the amount of the “normalization” adjustment.
This adjustment is particularly important when an executive’s actual compensation is much more than or much less than the calculated compensation, said Anderson, for example, when the key executive in a privately held business takes no compensation when the company’s sales are down significantly.
By “normalizing” the executive compensation, the business valuator is able to more closely reflect the executive compensation that would be paid to the executives by a hypothetical independent investor, said Anderson, an expert in business valuation services in Philadelphia.
If you are in need of a business valuation expert in Philadelphia, or if you require any other services of a forensic accounting expert in Philadelphia and the Delaware Valley, please contact the Philadelphia forensic accounting firm of David Anderson & Associates by calling David Anderson at 267-207-3597 or emailing him at david@davidandersonassociates.com.
About David Anderson & Associates
David Anderson & Associates is a Philadelphia forensic accounting firm that provides a full range of forensic accounting services in Philadelphia and the Delaware Valley. The experienced professionals at David Anderson & Associates provide forensic accounting, business valuation, fraud investigation, fraud deterrence, litigation support, economic damage analysis, business consulting and outsourced CFO services. Company principal David Anderson is a forensic accounting expert in Philadelphia with more than 30 years of experience in financial and operational leadership positions. He is a Certified Public Accountant, a Certified Fraud Examiner and a Certified Valuation Analyst. Anderson also has served as a divorce accountant and marital dissolution accountant in Philadelphia and the Delaware Valley.
