Financial statements record what happened. A valuation must determine what is economically sustainable.
When valuing an owner-managed business, the profit shown in the financial statements does not always reflect the earnings that a new owner could reasonably expect to maintain.
One of the most important reasons for this is directors' remuneration.
Unlike the salary of an ordinary employee, an owner-director's remuneration is not necessarily determined solely by the commercial value of the work performed. It may also represent a method of extracting profits, meeting personal financial requirements or rewarding the director for having built the business.
In other cases, directors deliberately take below-market remuneration to preserve cash or support growth. Some perform several roles without employing the people who would ordinarily be required to fulfil those functions.
Across several valuations of owner-managed businesses, we encountered different versions of this problem. Each required us to look beyond the amount disclosed in the financial statements and examine the commercial reality behind it.
Looking Beyond the Reported Profit
The purpose of normalising directors' remuneration is not to decide whether a director is paid 'too much' or 'too little'. It is to determine the cost that the business would reasonably incur to replace the director's operational contribution.
This required us to answer two fundamental questions:
- What functions did the director actually perform?
- What would it cost the business to employ appropriately qualified people to perform those functions?
We then considered the difference between the remuneration actually paid and the market-related replacement cost as a potential adjustment to maintainable earnings. Depending on the circumstances, this process could increase or decrease the earnings used in the valuation.
Case One: The Manufacturing Business
In valuing a privately owned manufacturing company, we identified that the director's remuneration could not simply be treated as an ordinary operating expense.
The director was both a shareholder and an active participant in the business. The remuneration paid therefore reflected more than the market-related cost of the director's operational responsibilities.
We analysed the role performed and estimated an appropriate market-related remuneration amount for a person carrying those responsibilities. The director's actual remuneration was then replaced with this commercial cost.
Where actual remuneration exceeded the estimated replacement cost, the excess was added back in determining normalised earnings. This did not mean that the expense had never been incurred. It meant that the full amount was not necessarily required for the business to continue operating under new ownership.
The adjustment increased maintainable earnings and consequently affected the value produced by earnings-based methods. Under a capitalised earnings or EBITDA-multiple approach, every sustainable rand added to maintainable earnings may have a multiplied effect on value.
The same principle affected the discounted cash flow analysis because the adjustment increased the forecast operating cash flows attributable to the business.
Case Two: Two Directors Over Several Years
A second valuation demonstrated why directors' remuneration should not be assessed by looking at only one financial year.
For this business, we prepared a remuneration-adjustment schedule covering the period from 2017 to 2024. The schedule compared the two directors' actual gross remuneration with an expected remuneration level, appropriately escalated over time.
This revealed the pattern behind the remuneration rather than merely identifying an isolated annual difference. A single year may be distorted by a once-off bonus, deferred remuneration, a temporary salary reduction, a distribution recorded through payroll, exceptional performance or the shareholders' personal cash-flow requirements.
By considering several years, we could assess whether the difference between actual and expected remuneration was recurring and therefore relevant to maintainable earnings.
The valuation adjustment was based on the sustainable commercial position, rather than selecting the year that produced the most favourable outcome. An adjustment should never be used merely to manufacture a higher valuation. It must be supported by the directors' responsibilities, comparable market remuneration and the operational requirements of the business.
Case Three: When Directors Are Underpaid
Directors' remuneration normalisation does not always increase value.
In another valuation, a growing service business forecast a significant increase in revenue from a new service offering. The directors were expected to perform several important functions themselves, including software development, project management, training and ongoing client support.
At the existing level of activity, this arrangement may have been achievable. However, the forecast contemplated approximately 18 projects. That raised a critical question: could the existing directors realistically deliver all these projects while continuing to manage the business?
If not, the company would need to appoint additional employees or engage external contractors. Those costs would have to be included in the forecast, even if they did not yet appear in the historical financial statements.
Without that adjustment, the forecast would recognise the additional revenue but not the full cost required to generate it. The resulting profit margins, cash flows and valuation would therefore be overstated.
This example illustrates an important principle: when an owner performs work without receiving market-related remuneration, the business may appear more profitable than it would be under independent ownership. A purchaser does not acquire the seller's unpaid labour. The valuation must recognise the cost of replacing it.
How the Adjustments Affected the Valuations
Across these assignments, the effect depended on the underlying circumstances.
Where directors' remuneration exceeded a reasonable replacement cost, the excess expense was added back when calculating normalised earnings. This generally increased maintainable EBITDA, forecast cash flow and the resulting valuation.
Where directors were remunerated below market levels, or where future growth required additional operational capacity, an appropriate replacement cost had to be deducted. This reduced maintainable earnings and prevented the valuation from relying on an unsustainable cost structure.
The adjustments affected different valuation methods in different ways:
- Capitalised earnings: Normalised earnings were divided by an appropriate capitalisation rate.
- Market multiples: Normalised EBITDA was multiplied by a selected market multiple.
- Discounted cash flow: Market-related remuneration and additional staffing costs were reflected in forecast operating expenses and cash flows.
The precise valuation effect was not necessarily equal to the remuneration adjustment. Taxation, forecast growth, working-capital requirements, discount rates and the selected valuation methodology also had to be considered. Nevertheless, directors' remuneration can be one of the most influential normalisation adjustments in an owner-managed business.
The Commercial Reality Behind the Numbers
To understand that reality, we considered questions extending well beyond the payroll ledger:
- Which directors worked in the business and what responsibilities did each perform?
- How much of their remuneration related to employment and how much represented a return on ownership?
- Would the directors remain after a sale?
- Could one replacement employee perform the same functions, or would several appointments be required?
- Would the existing management structure support the forecast growth?
- Were bonuses, benefits, vehicles, pension contributions and other forms of remuneration included?
These questions cannot be answered by applying a standard percentage or automatically adding back directors' salaries. The adjustment must reflect commercial reality.
Why This Matters When Selling or Buying a Business
For a seller, an unsupported remuneration adjustment may produce an attractive valuation that cannot withstand due diligence. For a purchaser, accepting the reported profit without investigating the owners' contribution may result in paying for earnings that cannot be maintained after the transaction.
A defensible valuation therefore distinguishes between the salary paid to the director, the cost of replacing the director's operational contribution and the return earned by the director as a shareholder.
That distinction can materially change the assessment of maintainable earnings and, ultimately, the value of the business.
At PRAVATA, we do not treat normalisation as a mechanical exercise. We examine the people, responsibilities and operating structure behind the financial statements to determine what the business would realistically earn under sustainable commercial ownership. Because sometimes the most important valuation adjustment is not found in the revenue forecast or the discount rate. It is found on the payroll.