There are three generally accepted methods for determining Reasonable Compensation for the owner of a closely-held business. It is important to match each method with the businesses size and business owner’s job duties.
- The Cost approach, aka many hats approach: Generally works best for small businesses where the owner wears multiple hats.
- The Market approach, aka the industry comparison approach: Generally works best for Closely-held SMB’s where the owner performs predominantly managerial tasks.
- The Income approach, aka the independent investors test: Generally works best for outliers.
The Market approach attempts to answer the question: How much compensation would be paid for the same position, held by a non-owner in an arms-length employment relationship at a similar company.
Frequently, the approaches for determining Reasonable compensation for a business owner are compared to the approaches used to value real estate. The market approach for appraising a home is most effective when used in track neighborhoods. The appraiser would run a search for three or four homes that have sold within the last year, that were in the same neighborhood and had a similar floorplan to the home he/she was appraising. He/she would then make adjustments based on differences in square footage, garage spaces etc. to determine the value of the home.
The Market approach (aka the Industry Comparison Approach) for determining Reasonable Compensation for closely held SMB’s is very similar. This approach seeks to determine the owner’s compensation by analyzing the compensation of employees in businesses of similar size and from the same industry (the same neighborhood). The market approach focuses strongly on the owner’s business type and the specific position held by the owner: typically CEO or General Manager. This approach then compares both the business type and the position of the owner to that of its peers to draw a conclusion for what Reasonable Compensation should be.
The market approach works well when only one occupation, (usually upper-management), is being compared to peers in the same industry, with similar company size and geographic area. Because of this, the market approach is favored when working with big-small companies (jumbo shrimp), and medium-sized closely-held businesses, where the owner is wearing only one hat: that of a general manager or chief executive.
Market Approach results generally include local (if available), state and national wage data. The theory: big-small businesses and medium business can pull from a larger area and attract candidates from around the state and/or country.