Are you selling your business? Do you own a business or just a salary? In economics, a business (also called firm or enterprise) is a legally recognized organizational entity designed to provide goods or services to consumers. However, the economic definition is based only on legal recognition. If your business only provides you (as the owner) a salary and no other current or future economic benefit such as appreciation or dividends, then your business may only be a salary and not an investment.
In my opinion, a business should be closer to an investment than a salary for it to be potentially more valuable (and therefore more marketable or liquid) to someone else. An investor has a reasonable expectation that, at some point in the future, the asset he built or purchased can be sold or resold for more than he invested. Even a reasonable investor that leverages debt to build or acquire the business (and does not make an equity investment of cash or other assets) would expect a return of his sweat equity upon the sale of the business and full repayment of all its debts.
So when is a salary a business? As a rule (and there are always exceptions to any rule), a salary is a business when it is excessive or above fair market. That is, when you as a business owner, can replace yourself with someone equally skilled and seasoned for far less money than you pay yourself, then you may have a business. The problem arises when you have too much personal goodwill in your business. Though you may replace yourself, if your reputation is largely inextricable from your business, then upon your death, disability or retirement, you may not be able to sell your business. Branding yourself, documenting your “know-how” and training your workforce are some ways you can transfer your personal goodwill to the business (and making it business goodwill).
So when is a business only a salary? As a rule, a business is only a salary when you pay yourself a fair market salary or less. However, though you may pay yourself more than fair market, if your excess compensation is less than what you would receive as a return on your business for an equally risky investment, then you may only have a salary. So if you only made a 5% return on your business, for example, and an equally risky investment should return 15%, then like any investment that is underperforming, it is less valuable (and may be only valuable as a salary). Comparing how similar businesses or asset classes in your industry perform (relative to size and growth) is a good measure of return on investment.
As a business valuation and forensic CPA, I use two sniff tests or sanity checks to determine if the business is a business or just a salary. My first sniff test is economic profit. Economic profit is the difference between return on investment and the weighted average cost of the investment, which includes both the cost of debt and equity capital after you pay yourself a reasonable salary. This value has to be positive. If it is positive, growing and greater than your competitors, you may have a valuable business. My second sniff test is return on equity. Simply, your return on equity should be at least equal to the risk of your investment. If the risk is 10%, for example, and you are returning 20%, then you may have a valuable business.
Despite the distinction between a salary and a business, there are buyers for both. People often buy businesses only to replace their salaries. The bottom line: businesses are more liquid and generally sell for more than salaries because they are seen by the market as investments that provide a reasonable salary and return.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.