What is Excess Compensation?
The Short Answer
Excess Compensation explained simply
Excess compensation is the extra money or perks a business owner pays themselves beyond what someone else would get for doing the same job. When valuing a business, this extra amount is added back to the profit. This helps show the true earnings of the business, as if a new owner were running it and paying themselves a market-rate salary.
Real-World Example
The Auto Repair Shop Owner
Imagine an auto repair shop owner who pays themselves $150,000 per year. A skilled manager in the same role would typically earn $80,000 per year. The difference, $70,000, is considered excess compensation. When valuing the business, this $70,000 is added back to the shop’s profit to show its real earning power.
Why this matters
Understanding excess compensation is key for valuing a business accurately. It helps buyers see the true profitability of the business, separate from how the current owner pays themselves. This ensures a fair valuation based on the business’s actual performance.
Always adjust for excess compensation when looking at a business’s financials. It gives you a clearer picture of what the business truly earns, which is vital for a fair valuation.
Always adjust for excess compensation when looking at a business’s financials. It gives you a clearer picture of what the business truly earns, which is vital for a fair valuation.
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