By Jason Watson, CPA
Posted Thursday, November 2, 2023
We raise the risk issue throughout our chapter on reasonable shareholder salary, but let’s touch on it some more. Please recall that shareholder distributions are financial rewards to the investor. While the detached abstract investor and the employee are the same person (you), it doesn’t change the theoretical demands of an investor. When a business valuation is calculated, discretionary cash flow is determined and then a risk premium is assigned to it. Simply stated, cash flow divided by risk (capitalization rate) equals value.
Here is a sample build-up method to determine risk-
| Discount Rate Element | Risk Value | Source |
| Risk Free Rate of Return | 1.37% | 20 Year Treasury Rate, Spot 11/30/2020 |
| Equity Risk Premium | 5.60% | Duff & Phelps, 2017 Valuation Handbook |
| Small Stock Risk Premium | 5.59% | Center for Research in Security Prices |
| Industry Risk Premium | 1.00% | First Research Data |
| Company Specific Risk Premium | 5.00% | |
| Total | 18.56% |
Company specific risk includes things like (just naming a few)-
- Operational History
- Volatility of Earnings
- Product or Service Concentration
- Customer Concentration
- Ability to Affect Pricing
Look at this list again, and compare it to your business. Are you relatively new? Are your earnings volatile (such as real estate)? Even 10% swings could be considered volatile. What would happen if Walmart stated in their shareholder meeting that they were predicting being off 10% next year? Heads would roll.
What about your service concentration? Think of an attorney- they pass the bar exam as a generalist, but quickly become a specialist (and forget all the other law he or she learned). Can you take your current skillset and find a whole new gaggle of customers in a different industry or sector? Maybe. Maybe not.
What about customer concentration? Are you a 1099 contractor who has one client who also happens to be your former employer? Huge risk, right? Heck, they’ve already fired you once.
What is your ability affect pricing? Usually none. Perhaps Apple but probably not you the mighty solo operator holed in your home office.
What are we getting at here? Would you consider a 19% return on investment (see table above) to be high? Not sure? Walk into your financial advisor’s office and ask for investments that only return 19% or higher. After the laughter, he or she might loosely show you some private equity investments or other syndicates that might return 19% if everything, and they mean everything, goes right.
What does all this mean? This means that any small business owner assumes a ton of risk, and that risk should demand a higher return on investment. In other words, a higher return on investment should demand higher shareholder (investor) distributions, and therefore lower shareholder salaries. This is a like a teeter-totter.
The entire economic benefit of the business can only be paid out in salaries and distributions (and perquisites or what we call “perks”). As such, if distributions are higher because of investor risk and the subsequent demand for more return on investment to meet the risk profile, then salaries must be reduced.
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