Based on the Factors Cited in the Case, the Compensation Taken by Kim Does Not Look Reasonable

Based on the factors cited in the case, the compensation taken by Kim does not look reasonable as it is very high as compared to compensation paid in similar industry and it is also very high compared to what is paid to other officers. If audited IRS will question and disallow the compensation.

However -

The five relevant factors from Elliots case are-

 Employee's role in the company;  External comparisons;  Character and condition of the company;  Conflicts of interest; and  Internal consistency.

In order to show that the compensation is reasonable, -

 Employee's role in the company;

Will have to show that he performed multiple roles, was the main person involved in getting business, worked late hours and has developed good relationship with clientele. He has personally guaranteed loans to the businesses and so on. If he quits the business will suffer badly or even sink.

 External comparisons;

Salary survey of competitors within the same industry and relevant to the situation and functions performed by him. Though the average salary of CEOs in similar industry is $500K, refer to additional functions performed by Kim and also the additional business and contacts brought in by KIM which as led to the value increasing by 7% annually.

When analyzing external factors, the number of jobs that he is performing must be considered. It is quite common for the owner of a closely-held business to perform tasks what two or three individuals would generally handle in another company. In such a situation, the combined salaries of the comparison company would be used for analysis purposes.

 Character and condition of the company;

Need to prove the reputation of the company, the clientele and offers from potential aquirers, Companys performance as measured against industry standards and other such factors supporting that the Company is at a very strong position and that it is because of the CEO and he needs to be rewarded adequately to be retained in this capacity.

 Conflicts of interest; and

Prove that the operating ratios are in line with industry norm and that salary structure is similar to other companies in similar industry. Investor analysis can be done to prove that in order to get the value from the stock the payment to CEO is reasonable. Any normal investor will be willing to pay the CEO the compensation for his services which has led to continuous growth of 7%. You might want to refer to Dividend history and compare it to industry standards to support the normal dividend paid or ploughed back.

 Internal consistency.

Bring out the fact that the CFO and VP (BOD) are also in agreement to the payment of this compensation knowing the contribution of the CEO to the profitability of this business.

This compensation arrangement has been consistent since a number of years in the past and has in a way motivated the CEO to perform more effectively. It has overcompensated in years of good performance and undercompensated in lean period. Independent investor/Return on Equity approach

Under the independent investor/return on equity approach, Kim’s compensation is unreasonable. CEO’s salary is substantially higher considering that it is appx. 80% of the Profits and will affect an arm’s-length investors return on equity. In fact, an upper bound on the executive compensation should be set up in a way such that an independent investor is able to realize a fair return on equity.

In order to prove that the compensation is reasonable-( In fact, I would argue in favor of the compensation being reasonable as most of the business is due to the CEO) (Similar analysis will also show if the compensation in unreasonable-depends on how you attempt it-it is subjective)

Fair Market Value Analysis-

Kim will have to prove that the fair market value of the company with the compensation(as taken) is in line with the investor expectations. This can be done by comparing return on their investment at the required market rate of return.

CAPM Analysis-

Capital Asset Pricing model can be used to determine the cost of equity. It is the expected (or required) rate of return on the firm’s common stock” that an investor would “expect to realize from an investment in a company with the similar risk and performance characteristics. If the CAPM is in line with what the investors are getting in the Corporation, than the compensation can be considered reasonable.

In additions the other factors(as discussed with reference to Elliots case above) would also be analyzed to support the compensation- especially multiple services rendered, leadership qualities and clientele and business development/7% annual growth and the in-line operating ratios(if it holds true).

It needs to be proved whether an independent investor would approve this compensation in view of the nature and quality of services performed and the effect of these services on stockholder returns. It needs to be proved that if the investor did not allow this compensation they would not be able to secure exception business growth and appreciation and hence the compensation should be reasonable.