Valuation experts use various methods to determine the value of a business, which is inherently dependent upon its income. Some of these methods involve examining earnings that will be available to a hypothetical buyer after he or she receives a fair dollar for running the business. Earnings available beyond compensation for running the business has value, and experts know how to turn that into a business value dollar figure.
Among the formulas requiring a figure for reasonable or replacement compensation are an excess earnings method, a capitalization of earnings method and industry specific rules of thumb.
The term "reasonable compensation" has its derivation in tax law. Business valuation experts have known for years that the figure used for reasonable compensation may have little to do with people's opinion of whether the amount is ''reasonable.''
In tax law, the term was used to describe something that was "not unreasonable." If something was not unreasonable, it would therefore be reasonable.
For example, the IRS may examine a corporation to determine if the salaries of its officers and shareholders included disguised dividends. Dividends, as you probably know, are not deductible to a corporation for income tax purposes. The "unreasonable" portion of an amount paid, as determined by the IRS, to an officer or shareholder for services rendered would be the amount the IRS would declare as a dividend.
Absent the IRS and its issues, an owner's income from his business-after expenses-is reasonable, even if it's a lot of money. Just ask the owners. They will tell you that the amount is reasonable for what they do.
Now, if you ask the same owners, "If you can hire someone to replace you, what would you pay for the right to operate as an absentee owner," they will probably give a different figure.
The business valuation profession has used various terms to describe the value associated with the line item "reasonable compensation" used in the valuation formula. Among them: replacement compensation, fair value of owner's services, value of owner's services, owner's replacement compensation, operator compensation and cost to replace operator.
Regardless of the terminology, the appraiser is trying to convey the same thing: the cost to replace the owner. This could be the average salaried person or a similarly situated professional. For simplicity purposes, we'll use the term ''replacement compensation."