Treatment of Bonuses to owners in Going Concern Value vs. Fair Market Value

We are often asked by valuation clients whether bonuses paid to agency owners based on profitability of the company, affect the agency’s value? Our answer is, “It depends.”

As you know if you are a reader of the PIPELINE or have had valuations done by Agency Consulting Group, Inc. or by any reputable appraiser of insurance agencies, agency value is based on future earnings potential under the circumstances specific to the agency valuation need. Future earnings potential is based on after-tax profits. If bonuses are paid to the owners and continue to be projected as agency expenses for valuation purposes, the agency’s net profits and earnings would be lowered, thereby lowering the value estimate. If bonuses are removed from expenses as discretionary, the profits reflect true total profit after normal expenses and value would increase because earnings would reflect higher numbers. The appraiser will project future bonuses or ‘purify’ bonuses out of projected agency expenses based on the circumstances of the valuation.

Fair Market Valuations

If valuing an agency as Fair Market Value for potential sale to an outside buyer, the bonuses owners currently pay themselves based on annual profitability would be ‘purified’ and replaced into Profit to build the potential value of the business to that outside entity. If the agency is sold, those bonuses would not necessarily be paid to the producers or new owners and would accrue to the retained earnings and eventually, to the asset value of the business.

Going Concern Valuations

If valuing an agency as a Going Concern for estate planning or internal transfer, if the owners decide to take some or all of the business’ profits as performance bonuses for themselves when profits dictate, they knowingly eliminate the potential of building cash reserves (retained earnings) and increasing the Tangible Net Worth of the business. In terms of bonuses taken regularly based on profitability to the owners, they would remain as expected expenses into the future. Net profit would be lowered accordingly and the corporate value would diminish based on lower Tangible Net Worth.

This is a matter of “having your cake, and eating it too.” The owners who take their profits as bonuses instead of leaving them in the agency to build value still get the full value of those profits since they take them personally each year. Those owners who leave some or all profits in the agency to support the business will build Tangible Net Worth in the company and, while taking less yearly, they will have a strong Corporate Value to pass on (and convert to the purchase price in any corporate sale) in the future.

No one stops agency owners from paying bonuses to themselves and/or to their employees from agency profits. In some agencies the owners choose to pay lower salaries and use bonuses to bring employees and themselves up to competitive market conditions. The size of bonuses depend on annual profits. The owners limit their exposure to loss by keeping salaries low and using supplemental bonus structures to keep their employees happy. The business sense of this position is not being discussed here. But if the bonus structure simply moves the employees and owners into moderate and competitive position, the appraiser must include the expectation of bonuses into the normal compensation schedule when projecting future earnings. Any new owner would be hard-pressed to maintain the loyalty of the employees without either replacing the supplemental bonuses with higher salaries or continue the bonus structure. This is another case where bonuses would be projected as future expenses as well as historical.

If you seek a valuation from us or from any reputable insurance agency valuer, make sure you inform him of the value of bonuses and the historical consistency with which they are paid. It will make a difference in the value of your business.