Natural love and affection in business valuations

We do a lot of irrational things for love and when it comes to business valuations we have to ignore natural love and affection.

When completing a business valuation on an earnings basis for family law matters (or for any reason), we are largely conducting an exercise of comparison - how do the profits (“earnings”) of this business compare with the earnings generated by others in the same industry?

Therefore, to make sure we are comparing apples with apples we have to adjust the earnings of the business for amounts paid to or on behalf of the owners and their family members so that the earnings reflect what would be earned on a commercial arm’s length basis.

The earnings of the business for valuation purposes should only include those expenses which have been incurred in the course of the ordinary operations of the business.

We often come across payments made for or on behalf of the owners or their family members, which are private in nature but have been included as an expense of the business.

For example, it is common to see life insurance payments made for an owner where the business is not a beneficiary, private motor vehicle expenses paid for the owners and their family members, mobile phone expenses paid for children and private travel expenses, to name a few.

Whilst a tax agent will check to ensure such expenses are appropriately deductible for tax purposes, as a business valuation expert our role is to remove those expenses which are private in nature from the earnings of the business.

Wages and superannuation paid for owners and their family members are examined as part of the business valuation process.

We understand that amounts paid to owners and their family members can arise for a number of different reasons such as income splitting, natural love and affection, wealth creation and for tax minimisation.

During the valuation process, we identify all wages and superannuation paid for the owners and their family members and then determine whether these amounts reflect what would be paid to an unrelated third party on a commercial arm’s length basis for fulfilling the same roles and duties. 

This adjustment in many cases can have a significant impact on the earnings of the business.

'Natural love and affection' goes hand in hand with asset protection.

If the business premises are owned by a related party, the business valuer should ensure that the earnings of the business are adjusted to ensure all rent paid is on a commercial arm’s length basis, being the amount they would have to pay for the business premises to an unrelated party.

All of the adjustments outlined above can result in adjusted earnings used for the purpose of the business valuation that differs significantly from the reported earnings in the financial statements and therefore a materially different resulting value for the business.

So whilst the payments of private expenses, wages, superannuation and rent (just to name a few) can be made to or on behalf of the owners and their family members which are considered normal for the business, the business valuation process identifies and adjusts these payments to commercial arm’s length amounts.

For more information

If you require more information on business valuations, please contact your local RSM office.