Family Business Quarterly
by Chris M. Mellen, ASA
Paul Phoenix, successful owner of Phoenix Electronics, Inc., sees the potential for growth in his company, but needs additional funds to finance that growth. He currently holds a 75% interest in Phoenix, with his brother owning the remaining 25%. Paul has given consideration to gifting some shares to his children, as well as to establishing an employee stock ownership plan (ESOP). However, he has been approached by several interested investors to buy equity in Phoenix Electronics. Banks have also expressed a willingness to loan him additional capital. As a result, his advisers have suggested that a formal appraisal of the business would be needed to address all these situations.
The events described above are some of the many that prompt the need for the valuation of a closely held family business. Several other reasons for determining the value of shares in such a company include income tax planning, including estate taxes, family limited partnerships (FLPs) and charitable contributions; buy-sell agreements; debt restructuring, including bankruptcy and recapitalization; litigation, including divorces, shareholder disputes and partnership dissolution; and strategic planning.
The problem for most family businesses is that there is not a ready market for their shares, unlike public companies whose shares trade in organized markets. The value of a public company is the market price of its shares times the number of shares outstanding. Valuing shares in a closely held company is much more complicated and less exacting. Valuing such shares requires the rigorous analysis of objective, historical and current information about the company, its product base, its industry, its markets and the characteristics of its stock.
Approaches to Value
A business appraiser must consider various approaches to valuing a closely held company. The credibility and feasibility of the value conclusion depends upon the skill of the business appraiser and his/her ability to utilize these approaches. Three of the generally accepted approaches are the income, market and asset based (cost) approaches.
The income approach assumes that today’s value of a business is based upon its expected future earnings. This approach bases value on the discounted value of a company’s future cash flows (i.e., the discounted cash flow method) or the capitalization of historic average, or normalized, earnings.
The market approach rests on the assumption that the value of stock in a closely held business can be determined by analysis of the price paid to acquire stock in similar, but public, companies. Financial ratios based upon the price of the shares of publicly traded companies are developed. Indications of value can also be derived from data on the prices at which entire companies have been sold.
The asset based approach bases the value of a company on the value of the underlying tangible assets; it does not include the value of goodwill and other intangible assets. Accordingly, it does not apply to many ongoing family businesses, such as Phoenix, which have value beyond their fixed assets. It may, however, be applicable for holding companies, capital intensive manufacturing companies, not-for-profit organizations and companies facing liquidation.
Other Factors Affecting Value
Although much quantitative analysis is needed to determine the value of a company, consideration must also be given to qualitative characteristics. Our example company, Phoenix, depends on one customer for 60% of its business and does not have a contract with that customer. In addition, Paul is both President and CFO of Phoenix Electronics because his brother left the business two years ago to pursue another venture. These factors may have an adverse effect on value. Paul’s experience and personal relationships may be difficult to replace; and if they are adequately replaced, it will be at a greater expense to Phoenix Electronics, thus reducing value.
Value may also be affected by such factors as a lack of product diversity, lack of geographic diversification and aged inventory. Furthermore, if Paul is considering an ESOP, he must realize that an employee vote would be necessary before any future sale of the company. This would reduce the company’s marketability, and hence its value.
Once an indication of value is determined by any one of the three approaches, and the company’s qualitative characteristics are considered, adjustments are often made for marketability, control or lack thereof. For example, since the shares of Phoenix, a closely held company are, by definition, not freely traded, a discount for lack of marketability would apply.
Every valuation contains both objective and subjective elements, and the value of a closely held family business is no exception. Factors, including the purpose of valuation, the standard of value, the interest to be valued and an analysis of the subject company must be addressed. A credible appraiser will make careful evaluation of each of these considerations, providing a solid framework for the valuation of your family business.
Chris M. Mellen, ASA, is Manager of Valuation Services at Tofias, Fleishman, Shapiro & Co., P.C., specializing in the valuation of closely held businesses.