It’s often the most important variable in a business appraisal assignment: the selection of what constitutes reasonable compensation for employee-owners. “For closely held businesses, in many cases, no single operating expense impacts the bottom-line profit as much as officer’s compensation,” said Ron Seigneur ((Seigneur Gustafson LLP, Lakewood, CO) at the recent Summit on Business Valuation in Divorce, co-sponsored by BVR/NACVA/ASA in Chicago.

Adjustments to owner-income don’t only occur in divorce cases, of course, but also to normalization assumptions in closely held business appraisals; measurement of personal versus enterprise goodwill; and valuation of non-competes. “Another emerging area is in evaluating excess or inadequate compensation challenges by the IRS,” Seigneur said. “The adjustment for reasonable comp is critical—and at the same time, one of the most difficult to quantify.”

Appraisers frequently use historical information to determine current compensation—but when applying market and other survey data, “be careful,” said co-presenter Sharyn Maggio, (Maggio & Co., Eatontown, NJ). “Misuse of the data can lead to incorrect valuations.” “You have to look at the salary studies to see how stale the information has become in the current economy,” Seigneur added. “Many surveys use data that are already a year old by the time of publication.” You also have to look at what was happening in the industry and the economy when the data was collected compared to now.

Know the data and what’s included. In the MGMA surveys, for instance (Medical Group Management Assn.), there’s a bias toward salaried doctors working for large universities or health sciences institutions. Appraisers should also check whether the data include: salary, bonus, stock options and other deferred compensation. To review the reliability of any survey, Seigneur and Maggio suggested a 12-point checklist, based on a recent article in the Business Valuation Update™. “If you use this checklist and can answer the questions, you’ll survive cross-examination,” Maggio said. The checklist is now posted first among the numerous free resources at BVResources.com.