by Dan Rabinovitch
University of Southern California
The valuation expert plays the role of the detective.He or she must delve through the complexities of a business’ performance; culture; key players and clients; and industry trends to arrive at a fair judgment of its worth.The IRS defines fair market value (FMV) as an amount the buyer is willing to spend and the seller willing to accept, neither under any compulsion to act and with equity to both.
This formula may shadow the very subjective “story” behind a business and its value. What is the mission of the company?What is the culture of the business?Who are the key players?For example, the opinion of a 5% stakeholder in a public company is not, by definition, weighty enough to dictate company decisions.On the other hand, if that same person holds 5% interest in a family business and she is the mother, no one is going to disregard her opinion.
Scott Adelson has performed valuations of closely held firms for eight years.It’s up to him to determine fair market value of a company. In a family business, he observes, FMV relates equally to those outside the business as those inside.
“Here’s a very real world example of that point,” says Adelson, “I sit on the board of a company that has two children, one in the business and one outside.The one who is not active in the business really wants cash and the other one wants stock.Their parents may not want to write checks to one and issue stocks to another at random values.They want to be fair about it so they’re setting a value for the stock annually, and during the course of the year they’re gifting stock to one child and cash to another.”
Why Value a Business?
Value is really the present value of future expectations, notes Jack Berka who has valued family owned businesses for 12 years.He finds he will take into consideration the value of the individual as part of the company’s value.Often, he says, the matriarch or patriarch of the family business is the rainmaker.They have all the contacts.If that person dies or leaves the company, value may be seriously diminished.
“One broad area for a valuation,” he explains, “is for estate taxes, either on the planning side, pre-death, or on the tax side, post death.Another area would be financing.A business going to their bank may want to show what the value of the stock is beyond the value of the hard assets.Another broad area for valuations is planning purposes.If I take a certain action, what does that do to my stock value?”
“Maybe a company has a buy/sell agreement between shareholders.Perhaps it was set up long ago when book value was the generally accepted method for determining value.The shareholders realize that today book value may have nothing to do with the actual fair market value.This situation would warrant a valuation,” says Adelson.”Another example would be a situation where the shareholders want to incentivize management with stock or stock options equal to one, two, ten times their salary.How much stock should they give them?”
Says Elisabeth Schutz, “Family owned companies will periodically receive letters of inquiry to purchase their company.It’s sometimes very useful for them to have their company valued by an independent third party.They can use that to judge whether or not the offers they are receiving are in the ballpark.”
“Insurance,” says Adelson.”How much insurance should I hold on a key person?If they were to pass away and I had to repurchase their shares.I may have a million dollars worth of insurance, but what if that person’s stock is worth over five million.I would be in trouble.People just guess at that, they take a shot in the dark.They can be substantially incorrect.”
Family Business Values
There are two ways to value a business.The liquidation basis hypothesizes the sale of all assets and payment of all liabilities.What is left over constitutes the value of the business.A going concern basis aims to determine the income stream of the company.Tangible assetsare considered as well as intangible assets, the goodwill of the management.One looks at the company’s ability to generate cash flow and income.At this point, a family business diverges from the behavior of a typical publicly held company.
“It’s very clear,” Adelson points out, “that in a public company, your number one goal is to enhance shareholder value.With family businesses, what is that primary goal?What is the management, the board, or the president of the company striving for?Well, it’s not always to maximize shareholder value.It may be to provide employment for certain individuals, it may be to be good to the community.It often is a number of things beyond shareholder value.I’ve known family companies that will get into another line of business because one son leaves his current employment and wants to join the family business.”Oh yeah,” they say, “we’ve been wanting to get into that business.Why don’t you start up that division.”
The end product of a family business may not always be limited to tangible goods or services.Elisabeth Schutz points out that closely held firms add value in ways that are not always measurable.They provide employment for family members.They dedicate themselves to remaining involved with their community.While these attributes may not translate into dollars and cents, their value cannot be disputed.
Steps in the Valuation Process
by Elisabeth Schutz, Vice President, Houlihan Lokey Howard and Zukin
1. Gather Company Data
Financial statements, schedules, business or strategic plans and financial projections, evidence of real and personal property, copies of significant contractual obligations, corporate records and company history, brochures, price lists, data on key personnel, lists of patents and copyrights, trade association membership and information sources, shareholder agreements, and articles of incorporation, etc.
2. Conduct Field Visits and Due Diligence Interviews
Interview management, review operations, discuss past financial results and future prospects for the company; interview professional advisors, interview customers, suppliers and competitors; assess the company’s operating environment.
3. Collect and Analyze Data on Comparable Companies
Moody’s, Standard & Poor’s, Valueline, Robert Morris Associates, IRS Source Book, Dun & Bradstreet, etc.
4. Review Industry
Standard & Poor’s industry surveys, U.S. Industrial Outlook, trade associations, brokerage house research reports, etc.
5. Review Adjustments
Evaluate the requirement to adjust for executive compensation, non-operating assets, non-recurring or extraordinary items, inventory methods and minority interests.
6. Analyze and Adjust Financial Statements
7. Compare Financial Analyses
Size and diversity of operations, liquidity, leverage, efficiency of operations, profitability, past and future expected growth.
8. Make a Comparative Assessment
Assess overall strength and weaknesses compared to the public companies, including qualitative factors such as key man risk, key client risk, etc.