Family business valuation - how important is it? Many family business owners consider business valuation an expensive exercise. Many also have the perception that it can be used for multiple purposes. Both perceptions are incorrect.
Family business valuation should be a process - one that does not always result in a formal written report. To be a valuable planning tool, it should be considered a part of the annual strategic planning process, not merely the result of an event requiring it.
Reasons for Conducting a Family Business Valuation
- Buying or selling shares to employees
- Retiring and selling to other family members
- Planning gifts to heirs
- Anticipating estate tax problems
- Providing adequate key man insurance coverage
- Tracking the progress of business plans toward achievement of results
- Performance-based compensation plans
- Providing a basis for compensating key non-family management (phantom stock plans)
Family Business Valuation - getting started
Some questions must be answered before launching a family business valuation.
- What is it that needs to be valued?
- Why is the business valuation needed?
- When is the value to be estimated as of?
Often these needs can be met - at least in the planning stages - without incurring the expense of a compete or formal family business valuation report. Experienced professionals can provide valuable help and assistance as business advisors, working with your accountant and attorney to plan equity transfers of any kind. By knowing which factors most affect value and which least, controlling owners can make more effective succession and ownership transfer decisions.
A family business valuation requires special expertise. For instance, the equity of a family business is far more difficult to sell than the equity of its publicly traded counterpart. It is less liquid and tends to be valued at lower multiples of various measures (pretax income, cash flow, owners profit, etc.). This is intuitively obvious when one considers that companies go public to create a market, raise capital, sell the founders' holdings, etc. - all reasons for the lack-of-marketability adjustments associated with estimating family, closely held, business share value.
One of the more popular devices used to transfer share ownership is the buy-sell agreement. The IRS is bound to accept the buy-sell price established between related parties and shareholders in a family business. They fight it but tax courts will uphold if these hold true.
- it is not merely a device to transfer a business interest to heirs for less than fair market value
- the agreement is real, it is part of a bona fide business arrangement
- it is similar to arrangements entered into by others in an arms length transaction
The important term is "arms length". Over- or under-valuation can lead to substantial tax penalties. Proper documentation of facts and reasoning is critical to sustainability. A business valuation will reflect these factors.
Why Financial Statements Don't Tell Much About Value
Readers of financial statements, whether reviewed, compiled, or audited, somehow presume that net worth is really net WORTH. Financial statements are prepared to present the results of the company's financial history for the past year(s). They are not prepared to imply an amount that someone would actually pay for your equity. A family business valuation, on the other hand. is prepared for the sole purpose of estimating what an informed buyer would pay to an informed seller. Family business valuation is an art, not a science, and it takes into account not only the numbers, but also everything else about the business that you or anyone buying it would consider important.
Seasonal Nature of the Business
In most agricultural businesses or others subject to peaks and valleys in revenue and expenses during the year, income is not evenly distributed over twelve months. The balance sheet will therefore look significantly different at the end of a peak income period than it might after a quarter of cash drains from ongoing operating expenses.
Here is how the "when" of the family business valuation can be especially important in a seasonal business. The value of the equity in any business is the sum of the present value of all economic benefits that can be derived from the assets less liabilities. The measurement of this value involves applying various multiples to cash flow, revenue or to net worth, each as of a specific point in time. It is possible for the inexperienced valuer or the uninformed user of a family business valuation to confuse a positive or negative capital position with financial stability and staying power.
Seasonal businesses as well as those that regularly borrow to fund working capital often end their fiscal year with negative working capital. This seeming negative or positive surplus from the normal or average level over a full fiscal year does need to be added to the operating business value just as we might add other surplus property. This is important to realize because if gifting or other transfers to the next generation is contemplated, legitimate lower values do exist in these slow periods of the year or in multi-year cycles. If you sell your crop in multi-year cycles, this concept is even more important. If you just sold all of your five-year stock for example and paid out the cash, you would have reduced the value of the company - and this would be reflected in a family business valuation.
Re-Stating the Operating Income of the Family Business
Most family-owned businesses are operated by the family for the financial benefit of family. Usually the family owns nearly all the stock so they certainly have every right to operate the business as they see fit within the law. The family business valuation challenge then in estimating the value of such an enterprise is to restate the operating income and expenses to reflect what services are needed to operate the business and what those services are worth in the marketplace.
This challenge cuts both ways. If Dad/Mom does two or three jobs for the business but draws only one salary, operating earnings need to be restated to reflect what the buyer will have to pay to have all these functions performed. If another family member's salary , which has also been charged to operating expense, is excessive compared to what will have to be paid for that service, operating income can be adjusted upward during the family business valuation to the extent that expense will not be needed. In some cases, the entire expense can be removed from future consideration since there is nothing of value provided! The adjustment must also consider the risk to the business of his possible sudden absence due to illness or death.
Surplus or Non-Operating Assets
You may have noticed, we used the term operating income in the previous paragraph. Often businesses accumulate assets not required for the production of income. These can be the excess land, the condo in Florida, the corporate jet. A business valuation will add such surplus assets to the value of the operating business.
Partial Interests and Fractional Interests
Minority shares versus majority, controlling shares, blocks of voting shares, family disagreements, active versus passive stock owners - all of these issues impact the family business valuation prepared for any specific purpose. Such partial interests are often confused with fractional interests in real estate when discussing discounts for less than 100% ownership positions.
- A partial interest is a unit or share, a percentage, and it usually refers to partnership or corporate stock ownership interests.
- A fractional interest is used in conjunction with direct ownership of some fraction of a piece of real estate.
Here are four key points the family business valuation must consider if the ownership of a business involves partial or fractional interests.
A partial interest in anything - particularly in limited or general real estate partnerships, joint ventures, etc. - is not worth its proportionate share of a whole entity
- The degree of value loss from that comparative proportionate share - the partial interest discount - can be surprisingly large: from as little as a 25% to as much as 75% (maybe even more)!
- Yet these same facts - negatives to the ability to sell a partial interest - can be used to advantage by creating partial interests to transfer wealth
- Family business valuation discounts must be properly documented to be defensible should they be challenged in an IRS examination
Consider the more important features of partnership interests that influence the family business valuation:
- regularity of dividend payment
- relative position in the line of claim to what is left in the event of a property or business failure
- past history of the property show total capitalization is sliced into various pieces
- strength, experience and the extent of their own capital involved of the general partner and/or management team in control
These factors, along with many others, need to be considered in the family business valuation when developing support for partial interest discounts. Sadly, we see many situations in which clients believe that they have adequate support with some "articles on the subject in my files if we are ever challenged."
Business Valuations: Top Ten Errors
The National Association of Certified Valuation Analysts compiled a list of
the ten most common errors found in valuation reports:
1. Failure to define purpose and standard of value.
2. Failure to discuss company background, industry, market, competition and
3. Inadequate financial analysis.
4. Mathematical errors.
5. Use of formulas with no explanation.
6. Failure to define earnings.
7. Inconsistent application of discount or capitalization rates.
8. Leaps of faith regarding rates, premia, discounts.
9. Improper use of comparable companies.
10.Failure to disclose information sources.
Valuation of the family business is an important part of the succession management process. However, there are many different reasons for ordering a valuation, including compensation packages for family and non-family executives, strategic planning benchmarks, risk management, phantom stock and estate equalization.
Environmental Problems - Your Worst Nightmare
Over the past 20 years, environmental risk and liability issues have emerged to become one of the most value-destructive factors facing family owned businesses, and are therefore major factors in the family business valuation. Worse yet, environmental issues can be a
for family business succession planning!
We believe that the potential costs of correcting possible environmental problems - most often hidden and certainly not advertised - can no longer be disclaimed away in the back of family business valuation reports. What kind of businesses and properties might have environmental risks? Anything that could in any possible way create ground, air or water pollution, either directly or indirectly.
The basis for today's environmental regulation is the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA). It was created to provide the authority and a source of funding for cleaning up hazardous materials released into the environment. The Superfund Amendments and Reauthorization Act of 1986 (SARA) contains provisions defining who is liable to pay for cleanup of contamination caused by past activities. In effect, SARA has created the need for special, professional assessments of environmental conditions at the time of each real estate transaction. These assessments will also influence the business valuation.
CERCLA and SARA define four categories of persons who have financial responsibility for hazardous waste cleanup:
- Present owners and operators
- Past owners and operators
- Transporters of hazardous material
- Generators of hazardous substances
Lenders are now almost automatically requiring environmental Phase I inspections before granting loans since they are deemed to be a party at interest. The property insurance companies are also becoming concerned because of their exposure to pay claims for things like:
- employee exposure to caustic or harmful elements;
- careless or poor management leading to physical damage;
- losses of any kind that their client company's product caused its customers.
The insurance companies in turn try to pass liability and costs back to their customers through increased premiums, limited or denied coverage, more demanding and stringent conditions on operations, and shifting claims back to the client by denying responsibility. All of these affect value, either by increasing costs, increasing risks or direct wiping out of assets to pay damages.
It is very satisfying to see the results of family efforts at creating value. But, it is most alarming to see and hear the somewhat casual attitude many take toward the potentially value-devastating effects of environmentally-unaware management. Environmental liability issues can quite literally devastate the family's equity in a matter of months - equity that it took generations to build.
Of course, a family business valuation must consider these potentially devastating effects.
Make it your opportunity to rethink how you can profit from cutting waste, lowering production costs, developing better relations with neighbors, and avoiding costly litigation and fines.
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