One of the common questions asked of an adviser by any family business owners is how to attribute a value to the family business and how coming up with an agreed formula can help remove challenging discussions at a later date. With a successful family business there is the challenge that all your wealth can be tied up in the business? How do you attribute a value to the family firm? What is it worth? Howard Hackney explores the key areas to think about below.
Valuations of any business are subjective and very much a matter of opinion and family firms are no exception. Above all, the family firm is only worth what a buyer is prepared to pay for it, and indeed the value that the seller is prepared to let it go for.
Any valuation needs to reflect the sustainability of the financial performance of the business and reflect the trust and value perceived to be in the business too. In that respect, like their non-family counterparts, family firms that are looking to sell need to make sure they professionalise the business operations and structures in order to make the business as attractive as possible to potential purchasers.
As Howard explains, “It is often said that company valuation is ‘an art and not a science’ and this is very true. At the end of the day a company is worth what a buyer will pay for it – wide variations both above and below a technical valuation are not unusual. In turn there will be different valuations for different purposes and it is to be expected that two independent valuers acting on either side of a transaction will come up with significantly different values. In this respect the old joke of asking an accountant ‘what two plus two make – the answer being what do you want it to make?’ is never more true.”
There are however a number of tried and tested methodologies and those that are often most useful for family businesses are the net assets as adjusted for open market values basis or the earnings basis.
The net assets basis simply uses the net assets of the business as shown by the financial statements. Complications can arise when there are non-business assets in the accounts such as investment properties but even here the basic principle holds true – the value of the company is the sum of the value of its assets less its liabilities. This of course does not take into account the value of ‘goodwill’ and this is where the earnings basis comes in.
The earnings basis looks at the maintainable future profits and then multiplies those profits by an appropriate multiplier. In arriving at these figures there is huge scope for subjective assessment of the ‘numbers’ to use. Where the earnings basis is less than net assets then it would be usual (but not an absolute given especially where the company is loss making) to use the net assets as the value. Where the earnings value is higher than assets the difference is by definition goodwill and the earning basis is likely to be the more appropriate.
However, as Howard adds, “the simple formulaic approach is easy to say but often difficult to implement because there are going to be areas that are subjective, and therefore lead to different valuations, something that then needs to be discussed and figures agree with potential acquirers. This obviously becomes more complicated if the buyer is the next generation and there are relationship issues that need to be taken into account. The older generation may need to extract wealth from the family firm and to be seen to be fair to the next generation and the next generation may have to borrow funds to finance the acquisition and will not want to borrow more than necessary either.”
The six areas of most contention in deriving the earnings value include:
1 - Maintainable Profits
Best practice tends to see a weighted average over a number of years being used but in a family firm where relationships may have been built up over many years by the outgoing family business leader, there could be a challenge as to how these business levels will be maintained.
2 - Normalised Profits
When assessing the profitability of a family firm it is important to compare the business practices as far as possible to open-market levels, especially when it comes to rewarding and remunerating staff. In many instances family firms pay family members more than the market rate for a role based on their financial needs and this will need to be ‘normalised’ when pulling together a family business valuation.
3 - Recent Trading History
Another area for debate will be the trends in profits and trading in recent years and the level of weighting that should be used. Integrated forecasts and the previous accuracy of management accounting forecasts will likely be the subject of some debate in this area.
4 - Exceptional Items
The results used in determining the valuation will need to take into account exceptional costs incurred by the business and adjust for these. Examples would include redundancy and reorganisation costs.
5 - Tax Rates
Multipliers quoted in the open market are calculated on post tax profits. While multipliers themselves can be adjusted to take account of the tax affect it is more usual to arrive at a post tax normalised profit and there is then the question of which rate of tax to use. It is usually the corporation tax rate but this does vary depending on the size of the company and government policy.
6 - Multipliers
If the above factors have a fairly high degree of subjectivity, it is the multiplier that is subject to the most argument. What figure to use is influenced by many factors including the business sector and the size of the company and indeed the economic climate. There are a number of possible indices ranging from quoted FTSE indices to others such as the BDO Private Company Price Index. While these are often in the low teens, a more usual multiplier for a typical family owned business would perhaps be between 3 and 8 although in the current climate this may be seen as optimistic.
Determining the valuation of any business is a difficult and often contentious issue and family firms need to make sure that they are best placed to gain the best value for what in many cases is their most valuable asset.
As Howard continues, “family firms that know that a transition between the generations or a sale is on the cards need to plan for the future and make sure they adopt best practice in all areas of the business to help them. Everything needs to be put under the spotlight and be addressed in order to mitigate discussions and debate further down the line. A good place to start is to ensure that detailed management accounts and integrated cashflow forecasts are prepared and maintained, areas such as depreciation are reviewed to ensure the company follows normal best practice and that areas such as salaries, reward and other benefits for family members are also considered against open market practices.”
“On a final note, family business owners always want to know what the business is worth but are very often not interested in actually selling to an outsider. Selling to a family member can be fraught with challenges when trying to maintain relationships and reach an outcome that is deemed fair and equitable to all parties. In my experience, including an agreed valuation methodology that is not subjective in any shareholders agreement or family constitution is a good way to transition the business from one generation to the next without any major issues arising.”