Volume 10, No. 1, Spring 2005

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Executive Compensation: Too Much of a Good Thing?

By Clayton J. Shultz, ASA, Senior Valuation Analyst

Introduction
The issue of excess executive compensation is one that is frequently encountered in business valuation. It is often the case, in privately held concerns, that the shareholders (those who own the company) and the executives (those individuals charged with managing the company) are one and the same. In the event that these two parties are related, there is an inherent conflict of interest with respect to executive compensation; the shareholders of the company set the salaries of the executives.

In a regular "C" corporation, these two groups of individuals are paid by the company's operations using two separate methods. Corporate executives are compensated, directly, using a blend of salary, perquisites and bonuses, whereas shareholders are compensated by dividends and, indirectly, through stock appreciation. A major difference between these two methods of payment is that executive compensation is paid before any corporate taxes are paid, which has the effect of reducing the corporation's taxable income. Dividends, on the other hand, are paid after the first level of corporate tax has already been paid and do not reduce the corporation's taxable income. Furthermore, dividends are subject to yet another layer of taxation at the shareholder level. Accordingly, there is a tax advantage to distributing the company's earnings in the form of executive compensation rather than through dividends because the executive compensation would be subject only to that individual's personal tax rate. This is a sound strategy as long as the amount of compensation paid to executive or executives is judged to be reasonble by the IRS.

In determining reassonable compensation, the question that be answered by the valuation professional is this: "What would an unrelated third-party pay in the form of compensation to a person of comparable skill and experience having the same duties and responsibilities?" In effect, the shareholder and executive must be put at arm's length from each other.

Factors Considered by the Courts
The five major factors considered by the Courts were initially set forth in Elliotts v. Commissioner been relied upon in subsequent Tax Court rulings. They include the following:

1. Role in the Company - The employee's position or positions in the company, responsibilities, and the number of hours worked;
2. External Comparison - The comparison of the employee's compensation with that paid to comparable employees in comparable concerns;
3. Character and Condition of Company - financial and operational size of the company, financial position and performance, sophistication of operations, and other company - specific factors;
4. Conflict of Interest - The relationship between shareholder and employee;
5. Internal Consistency - with regard to compensation of all employees.

Outside Sources
There are several outside sources of executive compensation data available that vary in sophistication and vigor of analysis. While the list of resources below is not exhaustive, these data sources are a good starting point for the analyst in determining the reasonableness of compensation. We encourage the reader to research each of these resources, to fully understand how data is collected for each resource and learn how to appropriately apply it to the situation at hand.

• Economic Research Institute (ERI) - ERI offers an interactive database for executive compensation, allowing subscribers to search for compensation data sorted by industry (using SIC codes), annual revenues, time, and geographic area. Executive compensation data is expressed in dollar amounts and is sub-divided into base salary and additional sources of compensation such as bonuses and perquisites. Data is further detailed by managerial position within the organization and is statistically displayed as the 10th and 90th percentiles as well as the median. Additionally, the ERI data can be queried to create a maximum reasonable compensation amount.
• Risk Management Association (RMA) - Formerly known as "Robert Morris Associates," this organization publishes the Annual Statement Studies, which is a publication of industry benchmark ratios. One of the areas studied in this regard is executive compensation, which is expressed as a percentage of total revenues. The companies studied by RMA are typically sorted by sales volume, and statistical data for executive compensation is limited to the median, the 25th and 75th percentiles. The RMA data pertains to all executives in the company and is not detailed for specific executive positions.
• National Institute of Business Management (NIBM) - Prior to its discontinuation in 2001, the Executive Compensation Survey published NIBM contained executive compensation data on a wide variety of industries. The data used was collected from companies with annual revenues of less than $25 million in most cases. The maximum, minimum, median, 25th percentile, and 75th percentile data are presented along with the breakdown of base salary and other compensation. The NIBM data includes compensation information for the President/CEO position as well as several other key executive positions within the organization such as Vice President of Sales or Vice President of Operations. Although the usefulness of this resource is diminished to some degree, as its data is somewhat older, it still can be used as a proxy in determining reasonableness of compensation today.
• SEC Filings - If the company the analyst is studying is large enough, compari- sons to executives in publicly-held companies may also be appropriate. These companies are required to report the compensation levels of their top executives. Depending on the comparability of the companies, this information may provide some useful insight in determining reasonable compensation for the subject company.
• Salary Surveys - Various government, nonprofit, and trade organizations compile salary surveys that the analyst may choose to rely on for information.

Independent Investor Test
Another method used for determining equity. reasonable executive compensation is the Independent Investor Test. This test and its corresponding methodology have been relied upon in numerous court decisions. The first step in this analysis is the determination of a required rate of return on the shareholders' equity. In developing this rate of return, the analyst should carefully consider all the factors that increase or decrease risk in the industry in which the subject company operates, as well as company-specific factors such as financial leverage, earnings history, and customer concentration among others.

The next step is the building up of the subject company's equity position. It's important for the equity amount selected to be an economic level of equity, which may differ from the company's historic book value. This can be calculated by using the equity value for the company determined through the income, market or asset approach to value. Another approach to estimating the economic value of the equity position, which is simple but effective, is to add an estimated portion of goodwill to the historic amount of stockholders' equity. However, this can be highly subjective.

Once an economic level of equity has been determined, the independent investor test rebuilds the subject company's income statement using very specific guidelines. The income statement should be similar to the company's historic income statement with the exception of the executive compensation line item, which is omitted from the expenses. This is done because executive compensation is the variable for which the Independent Investor Test will solve. Once the income statement has been rebuilt without executive compensation, the result is a level of net income after tax that excludes executive compensation. The final step is the computation of allowable compensation. The net income after tax without executive compensation is compared to the required return to investors. The difference is then divided by: 1 minus the applicable corporate tax rate. The end result is the reasonable pre-tax compensation estimate. Following, the reader will find not only the formula for determining executive compensation, but also an example of how the Independent Investor Test is applied.

Economic Equity Amount x Reasonable After-tax Return on Equity	= Required Return to Investors
Net Income After-tax without Executive Compensation - Required Return to Investors	= Reasonable After-tax Compensation Estimate
Reasonable After-tax Compensation Estimate ÷ (1 - tax rate)	= Reasonable Pre-tax Compensation Estimate

Estimated Tax Rate	35%
Year 1
Historic Total Stockholders' Equity	$200,000
Unbooked Goodwill (Est.)	50,00
0 Economic Total Stockholders' Equity	250,000
Reasonable After-tax Return on Equity	18.0%
Required Return to Investors	45,000
Net Income After Tax per Book w/o Officers' Compensation:
Net Sales	1,000,000
Cost of Goods Sold	(600,000)
Gross Profit	400,000
Officers' Compensation	0
Selling Expenses	125,000
General Expenses	125,000
Other Expenses	0
Total Expenses	250,000
Net Income Before Tax w/o Officers' Compensation	150,000
Tax	(52,500)
Net Income After Tax w/o Officers' Compensation	97,500
Computation of Reasonable Compensation:
Net Income After Tax w/o Officers' Compensation	97,500
Required Return to Investors	(45,000)
Reasonable After Tax Compensation Estimate	52,500
Divided by (1 - tax rate)	65%
Reasonable Pre Tax Compensation Estimate	80,769
Rounded To	80,000

Conclusion
This article has discussed two major methodologies for determining reasonable executive compensation for regular "C" corporations whose shareholder and executive roles are filled by the same person or persons. The first of these methodologies is the use of external data sources for comparison. The second is the Independent Investor Test. The analyst's conclusion of reasonable executive compensation will be the strongest and most reliable when: numerous data sources have been used, and the question of executive compensation has been approached from as many angles as possible.