We’ve talked about this before but it is worth repeating. There is a big difference between what a couple takes out of a business in terms of salaries and other benefits and what is or would be considered profits. Remember, when it comes to valuing the worth of a business, a typical real-world valuation relies upon calculating what is called excess earnings or profits., not necessarily what a husband and wife might take out of the business – those are really two different animals.
A quick example is in order. First, let’s assume Ajax Printing & Signs does $450,000 per year in sales. Bob and Karen, the owners of Ajax Printing, each withdraw $40,000 in salary and benefits each year. They employ one full time employee and one part timer. Their calculated sales per employee (SPE) is a relatively healthy $128,500.
In recent years Ajax has been reporting an average pretax profit of $25,000. When Bob sits down to arrive at the value of his business, he estimates the total profit for his company is approximately $105,000 based upon combining the two salaries and then adding to that number the “corporate/company profit” of $25,000.
Unfortunately, that’s not how a valuation works, not even a simplified one! Even assuming that the salaries being paid to both Bob and Karen are perfectly reasonable based upon their contributions and expertise, you cannot count or include the salaries and benefits paid to both of you when calculating profits or excess earnings – the latter being the fundamental calculation in determining the value of a business.
“Unfortunately, that’s not how it works out. Even assuming that the salaries being paid to both Bob and Karen are perfectly reasonable based upon their contributions and expertise, you cannot count or include the salaries and benefits paid to both of you when calculating profits or excess earnings – the latter being the fundamental calculation in determining the value of a business.”
Why? Because while it is assumed that a new owner would would take over Bob’s duties and responsibilities, he certainly could not perform the duties of Karen as well. She would have to be replaced. Like most buyers who purchase a company run by a husband and wife team, the buyer has to replace both spouses when he or she purchases the business. The new owner will almost certainly be required to hire and train an individual to assume Karen’s responsibilities! Karen’s $40,000, for the purposes of a valuation, is considered nothing more than one more salary or business expense required to operate the business, and when Karen leaves she must be replaced.
What if Karen is really only working part time and could be replaced by someone at a much lower salary? If that’s the case then indeed the excess salary previously paid to Karen would indeed be included in calculating excess earnings & profits. Calculating true “excess earnings,” the actual amount a business generates after covering all of its real-world expenses, is one of the most involved calculations we perform in arriving at company valuations.
By the way, just to clarify and avoid being called a sexist, the names, duties and responsibilities of Bob and Karen could readily be switched and reversed in the above discussion. Bob could be working for Karen and we have no intention or desire to imply who works for who in this situation. Note a similar article detailing what is paid to a spouse and how it impacts valuations appears elsewhere in this blog.