Family businesses bring valuation challenges
Family-owned businesses aren’t usually run like large public companies. From the Rockefellers to the Kardashians, working together can bring out the best — and worst — in families. Here are four key questions valuation experts ask when valuing these entities.
The terms “family business” and “nepotism” often go hand in hand. Although some business owners hire family members because they’re perceived as more trustworthy, many hire them out of obligation or to satisfy a desire to pass the business on to their offspring.
When valuing family-owned entities, business appraisers objectively consider whether family members are qualified for their positions and whether their compensation is reasonable. In some cases, management of a hypothetical buyer might want to consolidate family members’ positions and use fewer people to perform their duties. As a result, valuation professionals often make an upward adjustment to cash flow to reflect the excess expense of employing relatives.
But the reverse may also be true. Some family businesses overwork or underpay related parties. Consider, for example, business owners whose passion for their work and desire to succeed lead them to work exceptionally long hours.
When evaluating a related party’s compensation, experts look beyond the family member’s base pay. For example, they must also adjust for payroll taxes, benefits and extraneous perks. Perks may include such things as allowances for luxury vehicles, country club memberships or loans at below-market interest rates.
Family-owned businesses may engage in other transactions with family members, such as rental contracts, supply agreements and related-party loans. Experienced valuation experts know to inquire whether these transactions exist and are at arm’s length.
In many instances, related-party transactions are sweetheart deals that require adjustments to the company’s income stream. For example, suppose a boutique purchases the clothing line of a famous relative at a discount from what she charges unrelated retailers. If the boutique needed to be valued for, say, the owner’s divorce, the expert would consider reducing its cash flow to the extent that the related supplier’s prices are below market rates.
Family business owners tend to have a more personal management style that favors gut instinct and trust over formal written policies. Many family business owners also favor conservative business strategies and nonfinancial goals, which often lead to slower growth and lower profits.
Particularly when valuing controlling interests, experts consider how much a family-owned business would be worth in the hands of an unrelated hypothetical buyer.
In addition, the lax management style that characterizes many family businesses can lead to weak internal control systems — and even fraud. Valuation professionals take this additional risk factor into account and watch for the warning signs of fraud.
Although family businesses often rely heavily on one individual, key person discounts aren’t appropriate for every family-owned entity. These discounts are relatively rare and reserved only for those businesses that would suffer a significant monetary loss if the key person left the company.
The typical approach to quantifying a key person discount involves estimating the company’s monetary loss if the key person were to depart. Another approach is to estimate a percentage discount after considering several factors, such as the key person’s skills, the company’s financial position, employee turnover and management structure.
Owners can take preventive measures to safeguard their companies, such as requiring key managers to sign employment contracts. Family business owners may also consider implementing a viable succession plan or taking out a life insurance policy on the key person’s life that lists the company as beneficiary. Such risk minimization techniques generally offset any key person discount.
It’s all relative
Some of the world’s largest and most successful companies are run by families. But these businesses also can be somewhat quirky. Experienced valuation professionals recognize common issues that family-owned entities encounter and, when necessary, adjust their methodology to estimate how much these businesses would be worth to third-party buyers and sellers in arm’s length transactions.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.