Published August 30, 2015

Salary Versus Draw and the Impacts on Small Company Valuation

By Scott Dickes

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.

Scott Dickes - General Partner

Scott founded Hadley Capital in 1998 with the objective of bringing a professional investment strategy to the small company market. Scott has spent the better part of two decades financing and growing small companies. It’s in his blood … he grew up visiting small companies on family vacations with his dad who was also a small company investor.

Scott works with Gillinder Glass, S&S, Custom Label, Harris Seeds, ISS, and W.C. Rouse, and was previously the chairman of the board of Packaging Specialists, JRI Industries and Kelatron, all former Hadley Capital companies.

He enjoys traveling with his family, flying (instrument rated pilot), rock climbing, golf, paddle tennis, and water skiing. Scott recently took up beekeeping as a hobby.

Scott is a Trustee of the Hadley School for the Blind (no affiliation). He holds a BA from Duke University and received his MBA from the Kellogg School of Management at Northwestern University. Scott and his wife have two teenage children.