How is owner salary normalized when valuing a business?

Treadstone Law, an Ontario firm, says the owner’s salary, bonuses and benefits may be well above or below what it would cost to hire a manager to do the same job. If pay is lower, reported profit is understated. If it is higher, profit is overstated. The same article says normalized earnings aim to reflect what the business would earn under ordinary, arm’s-length management, and that normalized earnings is an input into a valuation, not a valuation itself. BDC’s due diligence guidance lists owner compensation and the impact of potential normalizations among the financial items to review, alongside financial statements and tax returns.

The basic adjustment

Treadstone Law lists, among the adjustments to ask about, the owner’s total compensation, including benefits and perks, compared with what a market-rate manager would cost. The difference moves earnings up or down by that amount. The earnings measure matters too: the article’s comparison shows that seller’s discretionary earnings (SDE) does not deduct a market management salary, while EBITDA typically does. Ask whoever prepared a figure what basis they used for the manager’s cost. BDC notes that you may want to involve experts in business valuation when buying.

Why the adjustment carries through to value

BDC describes market multiples as ratios derived from comparable transactions or public market data, applied to the company’s financial metrics such as revenue or EBITDA. If the earnings figure changes, the number the ratio is applied to changes with it. So the figure used for pay can change the result, and a seller should know which manager’s cost supports their own number.

Other items reviewed at the same time

Pay may not be the only adjustment. BDC says a quality of earnings report goes beyond standard financial statements to identify and adjust for non-recurring items, accounting irregularities and risks. BDC also suggests checking that the figures match what the owner has told you and that tax returns match the financial statements. Treadstone Law says every adjustment should be backed by documentation the seller can actually produce.