Earlier this week, I had a long conversation with an owner of a small business regarding his annual draw and how this draw, unlike a salary, is not reflected in his company’s income statement and why the difference is important in valuing a small business. This issue frequently arises when a small business owner is involved in running her company and someone needs to fill her role (whether the owner or someone new) when she sells the business.
A salary is a wage that is paid to an employee (whether an owner or not). Salary is an expense that is deducted from revenue to arrive at net income as reported on the income statement.
A draw is a cash distribution paid to a business owner and reflected on the balance sheet as a reduction in cash and a reduction in shareholders equity. A draw is not reflected on the income statement and has no impact on net income.
Below is a simple income statement that reflects the accounting treatment of a draw vs. a salary.
| $110,000 Draw | $110,000 Salary | Change | |
| Revenue | $2,500,000 | $2,500,000 | $0 |
| Expenses | 1,995,000 | 2,105,000 | (110,000) |
| Net Income | $505,000 | $395,000 | $110,000 |
The difference between a salary and a draw is important in valuing a small business because most businesses are valued based upon a multiple of earnings. If an owners’ compensation is not included as a salary expense, but rather taken as a draw, it will artificially increase earnings and, thus, valuation. The table below illustrates this valuation impact.
| $110,000 Draw | $110,000 Salary | Change | |
| Net Income | $505,000 | $395,000 | $110,000 |
| Purchase Multiple | 4.25x | 4.25x | 4.25x |
| Enterprise Value | $2,146,250 | $1,678,750 | $467,500 |
If an owner’s compensation is paid via a draw, it will not be included in her company’s earnings so we must adjust her company’s income statement to reflect this expense, reducing earnings. The reduced level of earnings is now reflective of the earnings a new owner will receive from operating the business. And, since most businesses are valued based on a multiple of earnings this will adjust the valuation of the company.
