Thread by @Capital4Value

#SMB Value tip:

How to remove excess or non-operating compensation or increase compensation in the financial statements during the normalization process

Its better to normalize earnings of a potential acquisition b/c you, as the new owner, can change this

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1/x Many times owners pay themselves over or under a replacement compensation (mainly due to tax reasons)

Many Owners may be paying family members higher than normal compensation rates

These items should be adjusted to 'normalize' the financial statements

2/x When buying a company you are gaining control

As a control adjustment you can operate the biz as you please & so its common to make control type adjustments such as normalizing compensation

A compensation adjustment is a controlling adjustment for valuation purposes

3/x
When adjusting compensation you must do 2 things, 1 normalize comp
2 normalize payroll tax

Payroll tax affects owners of S Corps & C Corps. LLC's have owner draws & no payroll tax

In general, the biz pays half the payroll tax & the employee pays the other half (7.65%)

4/x
When to normalize Payroll tax:
- Owner is leaving (& is taxed by the legal entity) & an employee is replacing them
- When an owner comp is adjusted for an an S or C Corp
- If an employee needs to be added, removed, or normalized

5/x To adjust compensation take your EBITDA:
1 Add back current salary
2 Add back payroll tax (~7.65%)
3 Deduct Market Comp
4 Deduct payroll tax (~7.65%)

(if removing an employee, do steps 1 & 2 only)

6/x
Be sure to normalize compensation & payroll tax when adjusting compensation

It's a straightforward procedure but crucial to get right