Glossary
Owner Compensation Normalization
Owner compensation normalization replaces what an owner chose to pay themselves with what the role would actually cost to fill. Owners of private businesses set their own salary for tax and personal reasons, not to reflect market value, so the reported figure tells you almost nothing about the cost of running the business under new ownership. At Treewalk we make this adjustment on nearly every engagement, and it is one of the few that regularly moves in the seller’s favour.
Why the reported number is meaningless
An owner-manager’s salary is a planning decision. Some pay themselves very little and take dividends. Some pay themselves heavily to reduce corporate tax. Some pay a spouse or adult child who does limited work. None of those choices describe what the job is worth.
For a buyer the only relevant question is what it will cost to have that work done after close. That has one of two answers, and which one applies depends entirely on the buyer’s plan:
The buyer will run the business.
The owner’s salary is added back in full. This is the SDE presentation.
The buyer will hire someone.
The owner’s salary comes out and a market-rate replacement salary goes in. This is the EBITDA presentation.
Setting the replacement salary
The replacement salary should reflect what the market charges for the work actually performed, not what the owner drew and not what the buyer intends to pay themselves.
That distinction gets confused often. Buyers sometimes want to strip out the previous owner’s salary and substitute whatever they personally plan to take. If the buyer intends to draw very little, that inflates earnings, and it is not a defensible basis. The business needs someone in that seat whether or not the new owner chooses to pay themselves properly for it.
Three factors shape the figure:
The scope of the role.
Many owner-managers do several jobs at once: general management, sales, sometimes the bookkeeping. Replacing them may need more than one person, or a role priced above a single job title.
Hours actually worked.
An owner working sixty-hour weeks is not replaced by one salaried manager at forty.
What the buyer can realistically hire for.
Local market rates for the role, in that industry, at that size.
Related adjustments that travel with it
Owner compensation rarely appears alone. The same review usually surfaces:
| Item | Treatment |
|---|---|
| Family members on payroll | Adjust to market rate for work genuinely performed, or remove entirely |
| Owner’s personal expenses run through the business | Vehicles, travel, meals, memberships, added back |
| Owner benefits and pension contributions | Normalized alongside salary, not separately |
| Rent paid to an owner-controlled entity | Replaced with a fair market rent for the lease the buyer will actually sign |
| Management fees to a related company | Tested for substance, often removed |
| Short-term consulting after close | Excluded, because the cost does not persist |
The rent one catches sellers out repeatedly. Where the owner also owns the building, the rent on the books is whatever they decided to charge themselves, and the buyer will pay a market rate under a new lease. That difference belongs in the earnings picture.
It sometimes helps the seller
This is worth stating plainly because sellers assume every adjustment is against them.
Where an owner has been underpaying themselves, or has been doing work the business never recorded a cost for, normalizing genuinely reduces the adjustment a buyer can claim. We have added to a seller’s own add-back list where they had not made a replacement salary adjustment at all and were entitled to one. Diligence done properly moves the number in both directions, and this is one of the categories where it moves up.
The reconciliation trap
One practical warning for sellers preparing their own numbers.
Where a marketing document presents an adjusted EBITDA figure with a list of add-backs beneath it, those add-backs must actually sum to the stated figure. We regularly find they do not. When the components in an information memorandum do not reconcile to the headline, the first question is not about the adjustments themselves, it is how the headline was derived at all. That is a credibility problem before it is an accounting one, and it colours everything that follows.
Frequently asked questions
What is a reasonable replacement salary?
Whatever the role would genuinely cost to fill in that market, for that industry, at that size. It should be supportable by reference to actual hiring, not chosen to reach a target earnings figure.
Can I use my own intended salary as the buyer?
Not as the basis for the adjustment. If you plan to pay yourself below market, that is a personal choice that does not change what the business needs to function. Buyers who model it that way tend to find lenders disagree.
What if the owner is staying on after the sale?
Then their actual go-forward compensation is the relevant cost, and any short transition arrangement is excluded because it does not persist. Where an owner stays only briefly, the replacement cost still has to be modelled for the period after they leave.
Does this apply if I am buying on an SDE basis?
No. On an SDE basis you add back one owner’s compensation and do not deduct a replacement salary, because the assumption is that you fill the role. Doing both double-counts the same job.
What about a spouse on the payroll?
Adjust to the market rate for the work genuinely performed. If the role is real, price it properly. If it is not, the whole amount is an add-back. This is a common and expected finding rather than an accusation.
Where to next
If you are preparing to sell and have been paying yourself for tax reasons rather than market reasons, your reported earnings understate the business, and normalizing it properly works in your favour. Our transaction advisory services team makes this adjustment on every engagement. Read EBITDA normalization adjustments for the wider adjustment set and buy-side due diligence for how each one gets tested. To talk through a specific deal, email Avnit Sekhon at avnit.sekhon@treewalk.com.
