by François M. de Visscher
Disagreements over the valuation of family business stock are prevalent and increasing today. The rising public equity market, combined with the current hot acquisition environment, has widened the gap between the high valuations shareholders can obtain from buyers and the low valuations that help minimize gift and estate taxes.
The situation is even more complex in families that are already transferring ownership to the next generation. Often there is an expanded shareholder base composed of relatively well-educated and sophisticated baby boomers. When these savvy owners seek liquidity of their stock, their value expectations are substantially higher than the “estate valuation” sought by their seniors for succession transfers and intrafamily buy-sell agreements.
The question for current owners is: In which direction do I go?
Market value no help
The typical answer is, “Well, just go with ‘fair market value.'” But it’s not that simple. In the United States, the most frequently accepted standard of value in business valuations is indeed fair market value. It is defined by the American Society of Appraisers as “the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.”
However, fair market value can vary significantly depending on the circumstances. For estate planning and gift purposes, where business owners hope to minimize taxes, fair market value will be the lowest possible value supportable under the law.
For the purpose of liquidity, however, the same stock would be valued at the highest possible price that a hypothetical outside buyer would pay under a set of investment criteria used by the buyer. Each of these valuations results in “fair market value,” but the results are very different because each grows out of a different purpose and premise. And despite the gap; neither is necessarily wrong!
In a family business, the dynamics between shareholders active in management and “inactive” shareholders who don’t work in the business further exacerbates the conflict. Inactive owners often wonder why they should hold on to shares when they could get a much better return by selling them and investing the proceeds in the stock market. Since they are looking to sell, they are eager for their shares to be valued at the highest possible fair market value.
But active shareholders want a low fair market value to reduce gift and estate taxes, and also to discourage the inactive shareholders from redeeming their stock through buy-backs, which can put a financial strain on the business.
Lack of trust between the two groups makes matters even more difficult. Family managers are better informed than the inactive shareholders about the business’s future prospects. And that suits the insiders just fine. If inactives knew all future growth potential, the managers reason, they would realize their shares were worth more. Hearing only negative news about the company, however, the passive shareholders start wondering what information is being kept from them.
Despite opposing purposes and mistrust, valuation differences can be resolved with a series of deliberate steps. Do estate planning before liquidity needs arise. Minimizing conflicts starts with early planning. Setting up an effective estate transfer using established estate planning techniques often dilutes disagreements over valuation. If done early, the valuation used for estate planning purposes is unlikely to be affected by the valuation used for liquidity purposes. Alternatively, wealth transfer techniques such as grantor retained annuity trusts or family limited partnerships alleviate the pressure to apply low valuation to the transfers, because the transfer valuation is reduced by the use of discounts.
Disclose information. Preventing conflict is generally better than having to resolve it. The best prevention is for insiders to disclose full information, including strategic plans, to inactive shareholders. Although a rosy future may entice the outsiders to expect a higher valuation, open communications will enhance family harmony, garnering support for the future plans and reducing undue desires for current liquidity.
Similarly, nonactive shareholders can help ward off conflict by educating themselves about valuation and adopting realistic expectations. It will help, for example, for them to understand that there are gradations of value, and that the shares they own are probably nonmarketable minority shares that receive a “minority discount.” Educated shareholders also know they must look at the after-tax value of their stock. When one family was at a standstill over a valuation issue between sellers and the company, the sellers’ lawyer was called in. By suggesting the use of various trust techniques, this very clever advisor was able to structure the transaction so that the proceeds of the sale would flow to the sellers on a tax-deferred basis. That in itself was enough to bridge the valuation gap between sellers and the company. Bring in an expert. When family members are at loggerheads, it’s time to bring in professional help, someone both sides trust to be unbiased and fair. Help could come from a valuation firm, an investment banker, or a financial adviser. The main role of the adviser is to get the family members-active and inactive-to agree on a valuation methodology for the shares to be sold. Then it becomes much easier to gain everyone’s consent to the valuation number that results.
Choosing a method
Financial advisers, family members, or whoever is trying to bring shareholders into agreement can use one of several valuation methods, or a combination. These include the following:
1. Looking at comparable publicly traded companies in the same industry to see what price their stock is trading at-such as multiples of earnings, sales, or book value. This valuation falls in the middle price category because it is based on marketable minority shares.
2. Doing a “transaction valuation”-looking at the price at which companies similar to your business have sold for and, again, at what multiples. Because these valuations involve the sale of a company, they fall in the upper price range.
3. Looking at future cash flows of a company based on its strategic plan and making a determination of the stock’s worth on a present-value basis. Called discounted cash flow, this method also produces a price in the upper range. 4. Determining discounts for nonmarketable minority shares and marketable minority shares.
Valuation doesn’t result in one number. Typically, it produces a range. With the help of an adviser, the parties can exercise judgment on where, within the range, they should situate their company. If all this still fails to bring about agreement, other techniques can be used. In one family business, a nonactive shareholder we’ll call Frieda was exceptionally suspicious of her two brothers, who were running the firm. She wanted to sell her one-third stake, but was afraid of being cheated.
Several provisions finally brought her around. For example, her shares would be sold to an employee stock ownership plan in order to defer the taxes on the proceeds. The brothers also agreed that if the company were sold within two years after Frieda’s shares were purchased, she would be entitled to a percentage of the profit.
A variety of tools can be used to settle differences over valuation, but the best tool is the one managers use to prevent mistrust: open communication. When nonactive shareholders are fully informed and know they will be treated fairly, they may never want to sell their stock.