Eight Ways of Valuing a Family Owned Business Reviewed by Momizat on . Managing Expectations of Sellers and Buyers Using the Right Standard of Value The author presents eight standards of value that a valuation analyst may need to Managing Expectations of Sellers and Buyers Using the Right Standard of Value The author presents eight standards of value that a valuation analyst may need to Rating: 0
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Eight Ways of Valuing a Family Owned Business

Managing Expectations of Sellers and Buyers Using the Right Standard of Value

The author presents eight standards of value that a valuation analyst may need to consider and discuss with a client. Each standard has a different set of rules and the valuations can vary greatly. Valuing a business is an art – not a science – even though careful calculations are made to arrive at an appraisal of the business. The author also provides some insight regarding how these are used and how the valuation analyst can protect their client.

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Valuations of closely held family businesses are confusing because of the varied reasons, uses, and purposes for the valuation. There is no one “right” way, since the value arrived at is contingent on the assumption used.  This is confusing to many business owners. In every engagement, an appropriate method should be determined depending upon the reason and use for the valuation. If necessary, the valuation analyst should discuss the standards of value with their client. This can reduce confusion and provide certainty.  In this article, I share my views on the eight standards that may need to be explained.

It is important to understand the differences of each method particularly based on its purpose.  In some valuations, even the date of the valuation is an issue. For example, the proper valuation date in a divorce could be the date the parties separated, date the complaint was filed, or a later date depending on the individual circumstances.  In some jurisdictions, the valuation date is the trial date. This can become further complicated if several dates are used and the gap between the earliest and latest valuation dates is a couple of years.

The identity of the ultimate recipient of the valuation is also an issue.  If the person selling a business requests the valuation, will it be provided to the potential buyer, or used as a strategy guide in setting the starting and bottom prices?  Likewise if the buyer requests the valuation will he be provided with all the information needed to form an opinion including negative data?  That is where the investigative skills and experience of the buyer’s appraiser comes in.

In formulating an owners’ buy-out agreement it is necessary to determine a value where either party could be the buyer or seller.  There, a balance of the interests needs to be considered and the valuation might not be the value used if there were a sale or divorce, but it is the “right” value between the parties for the purposes of the agreement.

Here are explanations of eight of the most commonly used methods.

Fair Market Value

Many people refer to a business’ value as its “fair market value”; I find that this is generally a misused term. Its derivation is from a 1959 IRS Revenue Ruling 59-60 which specifically addresses valuations for gift and estate tax purposes and does not necessarily provide a reasonable valuation for other uses.

Fair market is defined as “the price at which property would change hands between a willing and able buyer and willing and able seller with neither being under any compulsion to buy or sell and both parties having reasonable knowledge of relevant facts, with both seeking their maximum economic self-interests.” Implicit with this definition is that there is a “hypothetical” buyer and seller that are assumed to be well-informed about the property and the market for such property and are willing and able to complete the transaction using cash or cash equivalents and that the property would have been exposed on the open market of a period long enough to allow market forces to establish a value.

Part of the determination of a fair market valuation are upward adjustments for a partial interest with control or swing vote ability and downward adjustments for minority interest or lack of control shares and to recognize special difficulty in marketing those shares.

Limitations in this method exist when a current value is needed in a divorce or business dispute; when an actual sale is being negotiated; or where special attributes exist that are not reflected in the earnings history such as a patent or new procedure that is just taking shape.

Be aware that in determining values, consideration needs to be given to the reasons for the valuation, the actual buyers and sellers and pressures they have, family members, employees and other parties of interest, hidden agendas, negotiation skills of the participants, payment terms and periods, income taxes and tax based allocations, transaction costs and legal precedents, and rulings that guide and establish values. In the presence of any one of these, a fair market valuation might not be appropriate.

In lieu of “fair market value”, for example, the valuation might include the proposed consideration and a weighted average based on the previous five years’ earnings.  This would present a backward looking valuation using lagging earnings to determine the current value of the business. 

Standards in a Divorce

There are varying methods for matrimonial issues that extend from what a business might be worth in an immediate sale to what it costs to create or to recreate to what it is worth to the present owner – concepts not used in the fair market value method. Matrimonial valuations arise in state courts with each state setting their own rules and methodology and judges many times deciding the value in part by using their experience, knowledge and judgment.

This method would use the current or most recent year’s, and possible projected, earnings and could include the cost of recreating the business or goodwill.  The valuation analyst in these engagements will need to consider whether to tax-affect and/or deal with the DLOM and DLOC. 

Selling the Business

Valuing a business that the owner wants to sell can be done in a number of ways, but, at the end of the day, few buyers will base their purchase price on a valuation prepared by the seller. Additionally, many valuations prepared by advocates of the seller lack credibility because they are not considered to be independent.  As a general rule, the “valuations” prepared by a business broker or consultant are generally less robust than either a Conclusion of Value or a Calculation; few brokerage companies train the brokers and the values reached are occasionally  high and used as a means to secure the listing.

It is advisable for the owner to consult with a credentialed valuation analyst to review the broker’s opinion, get a range of the value, guidance on how to address the negotiation process, and perhaps even help determine the opening price and a price for which they should try to settle on, or a walk away value.

Considerations should also be given to the ultimate use of the net proceeds and cash flow that can be expected from the proceeds. Occasionally, the appraiser will suggest methods of structuring the transaction so the greatest cash flow can result from the sale proceeds. 

Sellers using this method would be more concerned with using the projected profits and would try to base the business on what the earnings will be in the next couple of years.  This is a forward looking valuation rather than what is used for the fair market value approach.  Occasionally an earn-out price is used based on future profits for a number of years after the business is sold. 

Buying the Business as an Investment

This refers to the value of the business’ cash flow and future profits considering the owner’s expectation of risk, return, potential, and type of involvement they will need to provide. On some basis most businesses are acquired with this in mind, but not all.

Here the buyer is interested in their ROI (return on investment).  They would look at the value as the present value of what they expect to receive over the three to 10 years after they acquire the business.  These investors usually accord more weight to the historical earnings and less to the projected values or cap rates (in the case of “investment property”, although that is also considered.  Where real property is a primary component, I find as a general rule that the real estate agents miscalculate the cap rate and do not understand other metrics used to assess the investment value.  A valuation analyst that is involved in this type of transaction is advised to work closely with a real property appraiser or seasoned real estate agent to counsel and assist the buyer. 

Job Value to the Buyer

This method values the business in terms of the job wanted in the business with the expected salary and benefits, in comparison to what the buyer could make if they had a comparable job, or any job they are reasonably suited for. 

Once the job is secured, the ROI is secondary and would just need to be somewhat equivalent to what they could reasonably earn on their funds had they not acquired the business.  This places a much greater value on the business than most of the other methods. 

Strategic Value

Included in this value are synergies and special features of the business that will add incrementally to a buyer’s current business, and for which the buyer is willing or should be willing to pay substantially in excess of its current value based on traditional valuations.

This could be in situations where a company wants to enter a market and it is less costly to acquire a business already in that market; where a company has a patent or secret process that the buyer can better exploit; where a company wants to eliminate the threat of a competitor or to acquire “critical mass” quickly, irrespective of cost, or expand their product line; or get access to a certain type of customer or the location of the business; where a business wants to maintain a supplier, or a supplier’s competitor; where the combination of two or more companies creates a major niche player, specialty business or one stop shopping source; where someone wants to protect their job or own the company they helped create or build; or where there is an ego value of ownership or the ability to become a participant in a well-known but limited field.

Many of these situations do not fall within the fair market value definition because there is no hypothetical willing and able buyer and willing and able seller with both having reasonable knowledge of relevant facts.

The value is based on what the buyer could earn because they own the business or even the ego value or ownership.  A recent example is the acquisition of the Los Angeles Dodgers by an investment group headed by Guggenheim Partners where they envisioned using the team to start a television network; or the Los Angeles Clippers by Steve Ballmer, former Microsoft chairman and its largest individual stockholder, who simply liked basketball and can afford to wait out the time period until the value catches up with what he paid. 

Partners’, Members’, or Shareholders’ Agreements

Different considerations go into valuing a business for a buy-sell agreement. And one agreement can have different valuations depending upon the reason for a partner leaving. Voluntary or forced withdrawal, retirement, disability and death, personal bankruptcy, or losing a professional license can call for different methods of valuation. Further, when there is a death or transfer to family members, the valuation has to pass IRS scrutiny. And today’s valuation issues might not be applicable many years down the road when the agreement is acted upon if there is no means of keeping the valuations current.

These valuations can get very complicated since various circumstances can have different amounts, and while the values might be reasonable, most businesses do not have the cash or cash flow or borrowing capacity to make the payments.  Accordingly many businesses put off executing such agreements.  However, such agreements are “wills” for the business and if not done, the survivor will confront much more difficult issues with more costly consequences that many times would be out of their control.  Valuations for these agreements if not done exactly the way they should end up being a compromise value that serves the purpose of the getting something done in case of an untimely death or disability or other precipitous event. 

Valuation in a Personal Financial Plan

Many owners value their business when they are doing financial planning for their future, retirement. or asset allocation. How the business is valued will depend on many factors, the least of which is the fair market value. Valuation for estate or gift tax purposes would be at the fair market value, but that might have no basis in reality of what the owner could expect to receive from a sale net of taxes or the ultimate cash flow from the proceeds.  

The values in a financial plan should not serve as an ego gratification when adding up the net worth.  What is most important is the cash flow from the eventual sale proceeds.  Valuations should lead to that cash flow making this different from any of the other purposes of a business valuation. 

Conclusion

Each method has a different set of rules and the valuations can vary greatly.  Valuing a business is an art – not a science – even though careful calculations are made to arrive at an appraisal of the business. The above indicates just some of the uses of a valuation and the considerations involved in the process.

Edward Mendlowitz, CPA, ABV, CFF, is partner emeritus with WithumSmith+Brown, PC, in New Brunswick, New Jersey. He has over 40 years of public accounting experience, is a licensed Certified Public Accountant in the states of New Jersey and New York and is accredited by the American Institute of Certified Public Accountants (AICPA) in Business Valuation and as a Personal Financial Specialist (PFS). The author of 24 books, Mr. Mendlowitz has written hundreds of articles for business and professional journals and newsletters and presented over 200 CPE programs. He writes a twice a week blog at www.partners-network.com Mr. Mendlowitz can be contacted at (732) 964-9329 or by e-mail at emendlowitz@withum.com.

Image courtesy of franky242/FreeDigitalPhotos.net

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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