The Kenney Rule refers to a guideline or formula used in the valuation of small, closely held companies, particularly when there is a need to allocate a company’s earnings between reasonable compensation for the owner-operator and the return on investment (ROI) for the business. The rule is often applied in legal contexts, such as in determining the value of a business for divorce proceedings, tax assessments, or shareholder disputes.

Key Points About the Kenney Rule:

1. Allocation of Earnings:
   • The Kenney Rule is primarily used to determine how much of a small business’s earnings should be attributed to the personal services of the owner versus the business itself. This is crucial in valuing the business separately from the owner’s labor.
2. Formula:
   • While the specific formula can vary depending on the context, the Kenney Rule typically involves:
     • Determining a reasonable salary for the owner’s efforts based on industry standards and comparable positions.
     • Subtracting this salary from the business’s total earnings to determine the amount that should be attributed to the business’s ROI.
   • The resulting figure, after subtracting the owner’s reasonable salary, is considered the business’s profit, which is then used to estimate the value of the business.
3. Application in Valuation:
   • The Kenney Rule is often used in small business valuations where the business’s income is closely tied to the efforts of the owner. By applying this rule, valuators can separate the income generated by the owner’s labor from the income attributable to the business’s assets and operations.
4. Legal and Financial Contexts:
   • The rule is frequently applied in legal disputes where the value of a business needs to be determined, such as in divorce cases, partnership dissolutions, or buy-sell agreements. It helps to establish a fair market value by ensuring that the owner’s labor is appropriately compensated separately from the business’s earnings.
5. Importance of Reasonableness:
   • The key aspect of the Kenney Rule is the reasonableness of the owner’s salary. This requires careful analysis of what a comparable salary would be for someone in a similar role within the industry. This ensures that the business is not undervalued (by over-allocating earnings to the owner’s salary) or overvalued (by under-allocating).
6. Criticism and Limitations:
   • Like any valuation method, the Kenney Rule has its limitations. It can be somewhat subjective, as the determination of a “reasonable salary” for the owner is not always clear-cut. Additionally, it may not fully capture the intangible value that the owner brings to the business.

Example of Kenney Rule Application:

• Small Business Valuation: Suppose a small consulting firm generates $300,000 in annual earnings. If a reasonable salary for the owner, based on industry standards, is determined to be $100,000, then the remaining $200,000 would be considered the business’s profit. This $200,000 would be used to estimate the value of the business, separate from the owner’s personal income.

Conclusion:

The Kenney Rule is a guideline used in the valuation of small, closely held businesses to allocate earnings between the owner’s labor and the business’s return on investment. It helps ensure a fair valuation by distinguishing between the income generated by the owner’s efforts and the income attributable to the business itself. The rule is particularly useful in legal and financial contexts where an accurate business valuation is necessary, though it requires careful consideration of what constitutes a reasonable salary for the owner.