One of the most misunderstood steps in valuing a small or medium business is adjusting for what the owner pays themselves. In most SMEs, the owner's salary often doesn’t match what an independent manager would earn. Until this difference is fixed, the earnings for a business valuation won’t show the true picture.

Some owners pay themselves below a market rate to leave cash in the business. Others take more out through salary, dividends or personal expenses than the role would command. Either way, the reported profit isn't the maintainable profit, and a business valuation has to work from the latter. That's why owner remuneration usually needs to be normalised before anything else happens.

Why does owner remuneration matter in a business valuation?

Because most SME valuations are built on earnings, and owner pay sits right in the middle of them. The common earnings-based methods, capitalisation of maintainable earnings, EBITDA multiples and discounted cash flow, all depend on estimating the sustainable earnings of the business.

Owner-managed businesses tend to carry distortions that get in the way of that estimate:

• salaries above or below market rates

• family members on the payroll

• personal expenses paid through the business

• dividends taking the place of salary

• profit distributions instead of wages

Leave these in and the business valuation misrepresents how profitable the business really is, in one direction or the other.

What is a market or replacement salary?

It's what the business would have to pay someone to do the owner's job if the owner walked away. It’s often called a replacement salary or market remuneration. It answers one key question: what would it cost to replace the owner with a skilled manager hired externally?

A reasonable figure reflects the size of the business, the industry, the complexity of the operations, the responsibilities of the role, and where the business is located. Once that salary is set, the financial statements can be adjusted to reflect it.

Example: owner paid below market

Take a consulting business with $1,000,000 in revenue and $300,000 in net profit. The owner pays themselves $80,000 a year, while a professional manager in the same role would earn about $180,000.

To find maintainable earnings, the profit is adjusted for the extra $100,000 of salary the business would have to pay:

• Reported profit: $300,000

• Adjustment for owner salary: $100,000 additional salary required

• Maintainable earnings: $200,000

At a 4x multiple:

• Reported profit basis: $300,000 × 4 = $1,200,000

• Adjusted basis: $200,000 × 4 = $800,000

The adjustment moves the value by $400,000, and the lower figure is the accurate one.

Example: owner paid above market

The adjustment can work the other way. Suppose a business reports $3,000,000 in revenue and $100,000 in profit after the owner's salary. The owner is paid $400,000, but the market salary for the role is about $200,000.

To find maintainable earnings, the excess salary is added back:

• Reported profit: $100,000

• Add back excess salary: $200,000

• Adjusted maintainable earnings: $300,000

At a 4x multiple:

$300,000 × 4 = $1,200,000

Without the adjustment, this business would look far less valuable than it is. Normalisation isn't always a haircut, which surprises owners who assume it only ever reduces the number.

Does it matter whether income is salary or dividends?

Not for business valuation purposes. Owners structure their income across salary, dividends and trust distributions, largely for tax reasons. A business valuation sets all of that aside and asks the same question regardless of how the money is drawn: what level of pay would the business need to cover the owner's role independently? Earnings are normalised to that figure whether the income currently comes through as wages or distributions.

What about personal expenses run through the business?

Owner-managed businesses often face distortion from private costs listed as business expenses. Typical examples are costs for private vehicles, travel not linked to work, family wages without a real role, home expenses, and lifestyle items like boats or RVs.

In a valuation, these are added back as normalisation adjustments. If a business reports $250,000 in profit but $50,000 of that is personal spending, the adjusted earnings are:

$250,000 + $50,000 = $300,000

The adjustment gives a clearer view of the underlying economics of the business.

Where do owner remuneration adjustments matter most?

They matter in any situation where the earnings figure carries weight, including selling a business, partner buy-outs, employee buy-ins, family law matters, shareholder disputes, employee share schemes, and business restructures. In each of these, both sides need confidence that the earnings in the business valuation reflect economic reality rather than how the owner happens to structure their income.

The strategic view

Owners tend to think about remuneration through a tax lens. A business valuation looks at it through a commercial one. A well-prepared business valuation separates the tax-driven income structure, the personal expenses, and the genuine operating earnings, so a buyer, investor or court can see how profitable the business actually is underneath the way it's been run.

Where this leaves you

Owner remuneration has a real effect on what an SME is worth. Most owner-managed businesses don't pay market salaries, so the financial statements usually need adjusting before any business valuation analysis begins. Those adjustments are what produce maintainable earnings, which is the base for most valuation methods.

Handled properly, remuneration adjustments give a clearer and more defensible view of value. Handled poorly, they distort it, sometimes badly.

Talk it through

If you want the earnings behind your valuation to reflect real economic performance, get started with a free 15-minute chat. Schedule an intro call.