The Importance of Business Valuation

By Chad Flanagan, CPA, ABV

Regulations, finances and growing pains can make it hard to understand the true value of your company. Knowing the value of your business is critical for acquisitions, exit-planning strategies and the general health and well-being of your business.

Plus, if your business is family owned, you may not even understand the full value of what you’ve built. This can lead to a decline in value later on in the sell process.

Business valuation is a critical step for any organization and is essential as you prepare for what’s ahead.

Understanding a business valuation

Business valuation is an independent appraisal of the worth of your company.

For family-owned businesses, a valuation is critical. For family businesses that include family shareholders, family that are non-owner workers and family not at all involved in the business, having a business valuation ensures ownership in the business is facilitated in a fair way to all family and stakeholders.

Further, a valuation is important for any stage business because it prepares you for a transaction triggering event, even when you don’t see one in your near future.

What do we mean by transaction triggering events? Here are just a few ideas:

Shareholder/employee quits

Shareholder/employee is fired

Shareholder retires

Shareholder wishes to sell stock

Shareholder becomes disabled

Shareholder death

Shareholder divorce

Company bankruptcy

When these types of things happen, they can cause a shift in your business and its future. It’s amazing how quickly your plans for your business may change when affected by these types of events. That’s why we recommend you consider including a well-defined valuation process in your buy-sell agreement.

This is especially important for family-owned businesses. These types of companies have spent years building their organizations from the ground up. While many believe they know the true worth of their company, it’s important to have third-party appraisal to tell you exactly what value is in the company, as well as give steps to help you prepare for future growth or exit.

The Importance of Conducting a Business Valuation Early and Often

Choose a single appraiser now, rather than when the transaction triggers events have already occurred. The appraiser can conduct annual or periodic valuations of your business. This enables all shareholders to know and understand the value of your business throughout its lifecycle.

Choosing an appraiser early has several benefits:

Selected appraiser will maintain independence with respect to the process and render future valuations consistent with terms of agreement and with prior reports.
Appraiser valuation process is known by all parties at the outset.
All parties know what will happen when a trigger event occurs, rather than scrambling to put together a game plan.
Because the appraiser must interpret the ‘words on the pages’ in conducting the initial appraisal, any issue regarding lack of clarity or terms would be resolved. Subsequent appraisals, either annually or at trigger events should be less time consuming and expensive than other alternatives.
Parties should gain confidence in the process.
Parties will always know the current value for the buy-sell agreement (this is helpful for planning all-around).
Appraisers’ knowledge of the company and its industry will grow over time.
This process creates a means of maintaining pricing for other transaction, enhancing “the market” for company shares.

The Impact of Discounts on Business Valuation

As part of an overall wealth planning strategy, many people will gift shares of stock to family members. When valuing a minority interest in a business (an ownership interest of 50% or less), it’s typical of buyers in the marketplace or a valuation analyst to apply minority discounts, which are more technically known as a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM). While sellers typically try to get top dollar, minority interest discounts can be helpful in certain tax planning strategies.

When valuing a minority interest in a business (an ownership interest of 50% or less), it’s typical of buyers in the marketplace or a valuation analyst to apply minority discounts, which are more technically known as a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM).

A DLOC is an amount or percentage deducted from the operating value of an entity to reflect the absence of some or all of the powers of control. When someone holds a minority interest in a business, they lack the ability to:

Implement business and operational characteristics;
Appoint and remove management;
Control the timing and amount of distributions;
Put the entity’s assets to their highest and best use.

In other words, the person buying into the business is receiving a discount because they are not receiving the full benefits of control.

A DLOM is an amount or percentage deducted from the operating value of an entity to reflect illiquidity (inability to quickly convert to cash) in privately-held entities when compared to public companies. In the valuation world, we refer to liquidity as “cash in three days”, which is expected when selling publicly-traded stock. However, when it comes to selling private companies, it takes much longer than three days to receive cash, which is why a DLOM is appropriate.

Discounts are extremely important to understand when negotiating transactions with investors. Investors’ primary way to receive a return on their investment is through distributions, which are primarily dependent upon the company’s financial stability, and diversification among the services and/or products and geography of the business.

Going back to the concept of “cash in three days”, investors will also look at the obstacles they could encounter if they decide to sell their interest in the future, which could potentially be affected by the company’s transfer restrictions and redemption policy. Therefore, appropriately discounting a minority interest is important as it could potentially make or break a deal.

Not only are discounts important to consider when searching for outside investors, but they are also a strategic tool that can be helpful when exiting a business. In fact, if you’re planning to sell your business, there’s a good chance you might encounter these discounts. It’s important to understand them so you know what price you can realistically expect from the sale of your business.

The Impact of Business Valuation on Family-Owned Businesses

While the goal for many family-owned businesses is to transition to the next generation, this might not always be the case. The Conway Center for Family Business found that nearly half of family business owners have no succession plan in place. And while 70% of family businesses hope to pass it on to the next generation, only 30% will be successful in doing so.

That’s why an independent valuation is essential for family-owned organizations. A formal valuation that takes place on short notice does not give leaders time to protect, let alone influence, the value of their company. When done early and proactively, family businesses can work to solve management and operational issues that are hurting the future sale or transition of the organization.

Even if a family-owned business does plan to transition to the next generation, it’s important to know the worth of the organization. This way family succession can come from a place of fairness as owners grapple with how to divide shares for the next generation, including both active and passive participants.

Business valuation can be done independently, but can also be included in larger succession planning conversations. Make your business valuation part of a comprehensive strategic planning process that not only tackles ownership transition questions, but also leadership selection and development and other family governance best practices.

What happens when transition to the next generation isn’t an option?
It all starts with knowing what your business is worth.

WE CAN HELP

Other items to consider in a business valuation

Other items to consider in a business valuation include:

How are shares of your company purchased or funded? Where will the money come from?

Who buys the shares? Other shareholders? The company? A combination?

The Company has several life insurance policies. Is the insurance adequate?

Are there other financial resources available to buy the shares?

What are the terms of the transaction? (down payment, interest rate, security, etc.)

Are there any restrictions on share payments under the company’s loan agreements?