owners compensation add back for an acquisition of minority interest

April 16, 2023

by a searcher from University of California, San Diego in Honolulu, HI, USA

I would like to understand how the owner’s compensation “add back” from the valuation indicative of a 100% interest in the business should be handled if this valuation were to be used to establish a price for a minority interest in the business instead.

Given that the current owners would continue under their current salary arrangement in perpetuity even after my acquisition of a minority interest, I feel the calculation of the SDE valuation should not include an "owner's compensation" adjustment. In other words, the owner's compensation "add back" should be removed to calculate SDE. Thoughts?

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Reply by an intermediary
from The University of Michigan in Bonita Springs, FL, USA

It sounds to me you will be one of many owners. If you are using the SDE to calculate value based on comparators, then you need to equate the SDE to one working owner. I'll offer an example to best illustrate. Let's say there are two working owners each taking a salary of $50K and they each work 40 hours per week. One owner manages job sites, and the other owner manages the office. I would start by adding back both of their salaries. Given it is easier to find office management, I would then add in the cost to replace the office manager for the particular area. Let's say an office manager in your town makes an average of $60,000. Then I would add back $100,000 less $60,000, for a net add back of $40,000 to calculate SDE (simplified to not including adjustments for taxes, benefits, etc.). In your case, you are forecasting a situation where there are three working owners. If your intent is to also take a salary of $50,000 and work 40 hours per week, I would add that burden in as well to any projections of future cash flows. Hopefully, your incremental 40 hours per week and $50,000 burden generates value for the entire partnership. Hope this makes sense.

Reply by a professional
from University of New Haven in Cromwell, CT, USA

I have a different perspective on this "valuation " issue. Using a control value by adjusting cash flow for owners compensation is more typically used to value - control positions. If you are investing as a minority shareholder and the control owner wants to add some or all owner comp to determine value then you should obtain an agreement prior to investing that limits compensation to an agreed amount and value should be determined based on that agree level of compensation. This does not mean that performance based comp should not be considered.

Minority investment should be undertaken carefully with as they say eyes wide open to ensure that the price you are paying is the value that you are getting.

It is about control of cash flow that determines the price to be paid

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