First question to ask re: executive compensation

BVWireIssue #69-1
June 4, 2008

Adjustments to owner compensation are arguably among the most critical when valuing a closely held business under the income approach, because every dollar modified has a multiple effect on the valuation conclusion.   But too often, business appraisers resort to a formula (excess earnings) and/or a survey of what similar professionals are paid—and the reasonable compensation adjustment can become the “tail” that wags the “dog” of the business valuation, according to Brian Brinig, JD, CPA, ASA (Brinig & Co., San Diego), who spoke at the California CPA 2008 BV Conference last week in Los Angeles.  “Ten years ago, I argued that we should not call it a ‘reasonable compensation’ adjustment.”  Reasonable compensation was already a term of art in tax law, and this precedent often confuses the issue (because there the focus is on unreasonable compensation).  Instead, the more appropriate term is “a fair value of the owner’s services adjustment,” Brinig said.  “Our objective is to determine the replacement value of the owner’s services to the business,” from the perspective of a hypothetical investor.

Thus, the first question appraisers should ask is: “What is the underlying asset that we are valuing?”   After defining the asset, the second question is, “Does it generate any income, separate from the working services of the owner?”   Goodwill valuation is not readily ascertainable by formula.  In many cases, its resale may be subject to actual or practical restrictions (as in professional practice firms or the goodwill of a neurosurgeon).  Often goodwill is not saleable at all, because “there is no ‘thing,’ separate from the professional that generates the income stream,” Brinig explained.   Using a salary survey implies that there is a separation between the value of the professional services and the income flow.   “If the goodwill of the business is not saleable, that’s a big red flag,” he said, which may indicate—albeit not conclusively, that there is no definable asset.  That’s what appraisers should examine before simply going to the next step in a formula or study.  “You’ve got to have an asset to value,” Brinig said.  “Comparative studies talk about the tail—and we need to keep our eye on the dog.” 

Can CPAs qualify on compensation?   The annual California CPA conference—which focuses on a single topic (this year, an in-depth look at executive compensation), featured some telling presentations on expert testimony.  Attorney Bob Kippur (Robert Kippur P.C., Beverly Hills) offered that he’s never seen a court exclude a CPA to testify regarding compensation.  He told the story of a local judge who responds to attorneys’ objections by saying, “You’re right.  Overruled.”  This means that the judge “doesn’t want to hear any objections,” Kippur explained.  “He wants to hear the information.”  Look for more Cal CPA conference tips on deposition testimony in next week’s BVWire™.  

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