Business Owner Motivations as Investor
vs. Litigant Should Not Color Value
“The Small Business Economy for Data Year 2005, A Report to the President”, released December 2006, states businesses with fewer than 500 employees account for 99.7% of all employer firms in the U.S. Very small businesses (with fewer than 20 employees) are responsible for half of the country’s nonfarm real gross domestic product. More interestingly, many of these businesses will struggle in achieving liquidity after the founder contemplates an exit. A good number of these business owners will face disruptive influences, such as a dispute with a partner or spouse.
The best financial expert sees both sides of the coin when addressing the complexities of intangible values incident to allocating goodwill; especially when a marital or partner dispute is involved. This article addresses the vulnerability of bias favoring the business owner often resulting in understating value(s). This article addresses the legitimate motivation of the owner as an active investor striving to enhance both his management efficiencies and technical knowledge to garner and secure market share while enhancing equity value. It also addresses the inescapable topics of double dipping and reasonableness of officer/owner compensation versus the distribution of profits and reinvestment in the business.
Brian Brinig, JD, CPA, ASA (Brinig & Co., San Diego), has argued that recasting/ normalizing officer’s [owner’s] compensation should not be referred to as a ‘reasonable [or replacement] compensation’ adjustment1. “Instead, the more appropriate term is a fair value of the owner’s services adjustment…from the perspective of a hypothetical investor.” This appears to align with the argument of portability or the probability of transferability of the knowledge and management skills of the owner. Certainly, some business owners and professionals with the ability to pay fees, often $20,000 or greater, might wish to retain an expert arguing nominal enterprise value due to substantiated high professional or officer/owner compensation.
Yet, this gives rise to two issues: The perspective of the investor and the anticipated economic “benefit” from returns on capital assets (dividends/income) versus labor/knowledge (wages). Private equity investors gravitate to one of two schools of thought. Value are in business assets and assumes leverage of the equity firm’s management team’s knowledge to increase business investment performance. The other sees primary value derived from existing company’s management’s skills that create value in the assemblage of underlying assets.
The second issue of economic benefit stems from value growth through reinvesting in the company versus taking most profits or a balance of both. What portion of profits should be attributed to what the owner earns as management compensation (base salary plus short- and long-term incentives) and what should the owner receive as an investment return or distribution is a significant analyst challenge.
After earnings adjustments are made, it is this figure that is considered as a proxy of the future earnings’ stream and is capitalized (risk/rate divisor as a percentage) in order to determine entrprise value that is assumed to eventually materialize.
Tax implications are often a driver in this issue. Reasonable compensation is often reflected as what the market reflects a person could expect to receive to perform a function with consideration of market conditions and individual talents. It’s understandable how these two items derived from the same source of economic benefit can lead to “double dipping” in divorce situations: That of support payments and allocation of a company’s intangible asset value(s) as opined by Robert J. Rivers, Esq., a Boston attorney2.
Enter Mr. Brinig, who opines “If there is no ‘thing,’ separate from the professional that generates the income stream… If the goodwill of the business is not saleable, that’s a big red flag… You’ve got to have an asset to value.” (Intangible value is the difference between the value of a business and its tangible assets, such as cash, inventory, equipment, accounts receivable, etc. The more service-oriented and/ or knowledge-based a business is, the greater likelihood the majority of its value will be intangible and the more difficult it will be to isolate the source of income.)
The term “goodwill” can be inadvertently comingled with all intangible assets, which may result in the undervaluation of business’ interest(s). This belief may not fully recognize that intangible assets have shelf-lives whereby the speed and duration in which value is measured differs and that to the extent an asset is difficult to isolate does not mean it doesn’t exist.
The underlying issue could be construed as, can an under- or non-performing asset exist (and have no readily perceived value), if there is no direct income generated at a discrete point in time? Consider the example of organizational improvement by enhancing personnel and processes. It may have a delayed economic outcome that inevitably causes greater patronage, revenues and profits, but with many moving parts of a company, the direct source(s) and values may be masked. Is this an active or passive income asset? Does passive mean non-existence? The same concept applies to patents, trademarks and copyrights; regardless, if income is presently derived.
Few business owners would suggest their companies solely have walk-away value. Further, they have an implied fiduciary duty to maximize the economic benefit and reduce risk to achieve the highest level of return on all assets held in a business while legally minimizing the impact of taxes on profits and transfers.
This would imply there is a willingness to regularly put forth the necessary efforts to ensure capital appreciation (growth) and enhance profits. Therefore, increased personal knowledge, such as more efficient use of time, may increase company earnings as well as the officer’s compensation. Although, the later result is not always the case, as the owner may wish to reinvest in company growth versus receiving higher immediate officer compensation. These attributes reflect similar ones expected of active asset managers versus passive investors.
So, from a seller’s perspective owners/sellers are likely to actively assist in the gradual transfer of ‘assets,’ such as business relationships, to new buyers seeking the highest price. Buyers may require an “earn out” provision in a sale to offset lost value from relationships that are unsuccessfully retained.
Therefore, the investor, regardless of buyer or seller, will identify which assets create what economic benefits, in what quantity and duration of time. One may surmise that if a non-compete agreement was required incident to a sale, then the personal attributes and knowledge of the seller hold value in a given market for a given time aside from the seller’s personal earning capacity/history.
Understandably, the more compensation allocated towards individual productivity and specialized skill, the lower the allocation that can be made for value creation towards the business entity in the absence of an understanding that this body of knowledge can and will be transferred.
What’s clear is (1) that there may be more than one valuation standard and approach that adequately captures the above time-value factors considered by arm’s length investors with certain return expectations and (2) that allocation of assets and economic benefit is a necessary, albeit not always precise, requirement. Also, the manner in which external (ex. market penetration and consumer confidence) and internal factors (ex. management depth/skill and debt/equity levels) influence value cannot be easily dismissed. Finally, simply because one party in a legal dispute lacks the liquidity to purchase an ownership interest does not mean value is absent, but rather a structured deal is needed.
1 The Eighth Circuit Court provided nine criteria for evaluating compensation. The criteria, virtually all aimed at current activity, were: The employee’s qualifications; The nature, extent and scope of the employee’s work; The size and complexities of the business; The prevailing general economic conditions; The prevailing rates of compensation for comparable positions in comparable concerns; The salary policy of the taxpayer as to all employees; In the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years; A comparison of salaries paid with the gross income and net income; and A comparison of salaries with distributions to stockholders. Arguably, Dugan v. Dugan also includes Age, Experience, Education, Expertise, Effort, and Locale. In Lopez v. Lopez, a California appellate court’s decision identified several factors that valuators should consider before expressing an opinion including: age and health; demonstrated past earning power; reputation in the community for judgment, skill and knowledge; and comparative professional success.
2 “The concept of double-dipping refers to the double counting of a marital asset, once in the property division and again in the support award. This theory is premised upon the fact that the same cash flows capitalized to determine the present overall value of a spouse’s business (an asset subject to marital distribution) are also considered a component of that spouse’s total income for support calculation purposes. More specifically in the context of divorce proceedings, where the court uses a business owner’s “excess earnings” to value the business and also fixes support based upon that spouse’s total income (inclusive of the excess earnings used to value the business), a double-dip can occur. In order to fully understand the double-dip issue, an understanding of basic business valuation theory and methodology is required.”