Valuation of Closely Held Family Businesses

Introduction

Family businesses are often the largest assets of the business owner. Shareholder disputes, divorces, estate partitions, etc. can lead to a need for an experienced appraiser to perform an impartial value of the business. Valuing closely held businesses can be more challenging than meets the eye. Just because a business is smaller does not necessarily mean it is easier to value. There is a unique set of issues to valuing a family business. These issues require subjective judgment to be made in order to come up with a fair market value of the business.

Valuation Methodology

The three approaches to valuing a business are: the market approach, the asset approach, and the income approach. The market approach uses qualitative factors to find comparable companies that have been sold, and then applies their sale price multiples to the target company being valued. A few of the qualitative factors used to investigate similar comps are the entity’s industry, the entity’s growth, the entity’s risk, the size, and the types of products/services. The asset approach looks at what the assets of the business are net of liabilities and can be performed by getting an appraisal for an accurate fair market value of the assets. It is essentially the value of the company if the business were to be recreated. Finally, the income approach looks at the present value of the future earnings stream to arrive at a value.

Valuation Discounts

There are situations where the fair market value, using one of the valuation approaches mentioned above, will need to be adjusted. A discount for lack of liquidity would be applied when closely held businesses are not easily liquidated and sold. A discount for lack of marketability will be used when a business cannot be sold, which usually occurs when there is a minority interest owned. However, an adjustment would also be made when the business owner does not have a majority stake in the company and, therefore, does not possess full control over the business. These are the most frequently used discount factors.

Normalization Adjustments

Mixing business and personal expenses is a key issue when valuing a family business. An example of this issue would be a company paying for travel expenses. This is a business expense if the travel is business related (meetings or conventions), and this is a personal expense if the travel is for personal reasons (vacations or other family matters). The biggest normalization issue is salaries and wages. Salaries often do not reflect a normal fair market value salary, because the salary is up to the owner’s discretion. In addition, owners will sometimes put family members on the payroll even if they aren’t active in the operations of the business. These adjustments require the appraiser’s judgement to appropriately classify theses expenses. An in-depth analysis of the company’s accounting records is usually required to normalize the income to what it would have been minus the personal expenses. This is important because there can be a significant difference in the economics of the business once personal items are removed. Other issues may arise if the company does not keep up-to-date and accurate accounting records.

Regulatory Requirements

Personal goodwill (the additional value a business has above a normal return on assets based on its name and reputation) poses its own unique issue. In the case Thompson v. Thompson in 1991, The Florida Supreme Court ruled personal goodwill was not a marital asset. This ruling requires the appraiser to distinguish between personal goodwill and enterprise goodwill. Enterprise goodwill is derived from characteristics specific to a business, regardless of who owns or operates it. The difference can have huge ramifications on the value for each party. For this reason, it is important for a valuation expert to be mindful of the laws governing the valuation.

Conclusion

No valuation is the same, and each one presents a different set of challenges that can have an immense impact on the client. That is why it is important for each party to protect their interests and have an experienced and objective appraiser.