I just finished writing a lesson in my course, Ready…Set…SELL, where we discuss salary and how to handle it in a M&A transaction. We run through this in detail in the course, but it is a question that comes up a lot, so I thought I would briefly touch on the topic and the strategy around it here.
An Example of Determining Your Salary Post-Sale
First off, most sellers do not pay themselves a market rate salary. A few do, but most don’t because they want to minimize payroll taxes. Instead, they will take the bulk of their earnings as a distribution – assuming of course they are incorporated as a pass-through entity and not a C-corp.
Here is a typical example:
Robert’s salary – W-2 $100,000
Annual distribution from company 350,000
Total compensation $450,000
Robert runs a $8M business with 25 employees, so it’s likely his market salary is more than $100,000, but not as high as $450,000. But Robert has gotten used to receiving $450K each year and now has a lifestyle that requires a higher salary.
Robert can do one of two things when it comes time to sell:
- Ask for a market rate salary – which we will assume is $350K, or
- Keep his lower salary to avoid a negative EBITDA/normalization adjustment, and use his proceeds at sale to help supplement his salary
The negative EBITDA adjustment will result in a number which is the difference between market rate ($350K in this example) and what he pays himself ($100K); this is then a $250K negative adjustment.
Robert’s decision as to which option he takes is really going to depend on how long he plans on staying with the company, as well as the multiple of EBITDA he receives for his company.
How To Calculate Your Best Option for Post-Sale Salary
If Robert only plans on staying two years after he sells, and receives a 6x multiple for his company, he would be better off taking this lower salary. Here is how this plays out:
The negative multiple adjustment of $250K (discussed above) will result in a reduction in valuation by $1.5M ($250,000 x 6 = $1,500,000). If he only plans on staying two years post-close, even if he did get a salary of $350,000 per year, he would still be losing $1M in value.
This $1M loss in value is calculated like this:
- $250,000 increase in salary x 2yrs = $500,000 ($350,000 new salary – $100,000 current salary is $250,000). He would have gained $500,000 in salary.
- Loss in overall valuation is $1,000,000: ($1,500,000 – $500,000 gain in salary)
This would only work if he actually planned on staying 6 years; then he would break even.
Of course, this calculation and the breakeven period is really a function of the EBITDA multiple and the salary differential. But in almost every case, it makes more sense to take the lower salary if you don’t plan on staying at least 4 or more years.
How Acquisition Type Affects Post-Sale Salary
Sometimes you will not have an option to pick the lower salary, especially if you are an add-on or tuck- in acquisition instead of a platform acquisition. The company will want to pay you market rate regardless to make sure that you will stay, especially if you don’t have a long earnout period. But, if you have the option, this is a worthwhile calculation to go through to figure out your best scenario.
I once had a client who insisted on being paid $650K per year because that was what he was used to living on (current salary + distributions), vs the $250K salary which was market rate. Once I showed him the calculation of how that would affect his cash at close, he quickly changed his mind and decided he could live on a lower salary given all the cash at close he would receive (which would by far make up for the reduction in annual take-home pay).
When to Determine Your Post-Sale Salary
This next point, however, is key: You must figure this out BEFORE you calculate your normalizations and present them to your prospective buyer. Then, stay the course on that salary. You cannot say you will keep your low salary (to avoid a negative EBITDA adjustment) and then try to negotiate a higher one at close. Buyers understand this well, and while they are happy to give you a larger salary, they WILL make the adjustment accordingly, reducing your cash at close.
My final piece of advice is to be realistic about what kind of salary you need to sustain your living currently, or how you plan on supplementing it with the cash you receive at close. Either way, just know a decision today can have a have a major impact on your valuation going forward. So be sure to think it through.
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