How Employee Compensation Destroys Company Sale Value

There are all kinds of things that reduce value in a company, but we’ll talk about one of the bigger value destroyers that many advisers don’t even talk about:“Employee Compensation”.

Let’s say you sell your company. From the buyer’s perspective, your employees can be put into two groups: Group 1 has your key employees as well as your productive employees; Group 2 are unproductive, lazy and overpaid employees.  

The problem comes from the fact that most companies pay their employees using arbitrary salaries and arbitrary bonuses with no correlation to results. The problem worsens as employee tenure lengthens, not just because of cost of living increases but also because of loyalty bonuses. As a result, many of your employees may be grossly overpaid with little to no regard to their market replacement value, which in many cases is significantly lower.

This creates an opportunity for the opportunistic buyer. The new buyer will choose to, in some cases, replace overpaid as well as non-performing employees with employees at market wages, or eliminate positions altogether by leveraging efficiencies.

The reality is that Employees = Cash. Because most companies don’t align employee compensation with underlying performance, they have bloated labor costs. This lowers earnings and the company valuation, and therefore serves as a great purchase price subsidy for the buyer due to the Magnifier Effect. For example, if you have $200,000 in inefficient payroll, at a 6X multiple, it will cost you $1.2 million in lost sale value because it ended up being a $1.2 million subsidy to the buyer.

So what’s the fix? For starters, you need to take a look at your payroll and honestly assess it for bloat. Next, revisit your company’s employee compensation practices and start connecting employee compensation to results. While you need to pay a competitive wage to your employees, you need to ensure that you have smart employee incentives that reward the employee in a logical and sustainable way.

It’s also important to remember that employee incentives should be both financial and non-financial to create a balance between near-term profit growth and long-term shareholder value. For financial incentives, a method we have used effectively with companies is gain sharing. The premise is simple–if an employee or department, creates a gain in some area, the business shares a portion of that gain with the parties responsible. But if a department, team, or employee does not create a gain, they are simply not entitled to any gain sharing. In many cases, gainsharing can also serve as a great alternative to giving your employees equity in the company. So the bottom line is, don’t let poorly structured compensation serve as a purchase price subsidy to your future buyer.

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