Most owners of privately-held businesses believe that they
know what their company is worth. As they have worked to
build the business, often from the ground up, they feel
that their intuitive value conclusions accurately reflect
the fair market value of the firm. In many cases, these
business owners are biased in their views towards the firm,
and therefore, have an inflated sense of value associated
with the business. Though a business owner has their own
opinion as to what the business is worth, their value may
differ substantially from the value that could be realized
in an arms length transaction between a willing buyer and a
willing seller. Without a formal valuation of the company,
the business owner often has nothing other than a gut
feeling to support the value that they attach to the
business.
Many business owners are reluctant to hire an independent
valuation professional to conduct an initial valuation of
the company (let alone an annual valuation) if they do not
perceive the need for one. In many cases, there is little
perceived need for the owner of a very small business to
have a valuation performed, unless of course the owner
plans to leave the business to children, needs a loan from
a bank when the company's assets alone cannot support the
loan, or seeks to sell all or part of the business. These
business owners often are individuals who have started or
acquired a "lifestyle" business-a business that provides
the owner with a job and enables the owner to maintain
their desired lifestyle. The lifestyle business could be
thought of as a hobby for the business owner-a hobby that
earns the owner money.
As compared to a lifestyle firm, some entrepreneurs seek to
establish a transgenerational enterprise-a firm that is
skillfully managed to create long-term value and wealth for
successive generations. These firms typically exhibit the
same seven characteristics of successful transgenerational
enterprises-a compelling vision, professionalized
management team, a long-term ownership plan/strategy,
effective communication, good corporate governance, a clear
succession plan, and a comprehensive strategic plan. As a
result of the need to ensure and evaluate successful
creation of transgenerational wealth, many privately-held
and family-owned businesses, particularly those that have
survived multiple generational transfers, have instituted a
policy of having an independent business
appraiser/financial analyst conduct an annual valuation of
the firm.
Many firms of various sizes and different phases of the
corporate life cycle have recognized the benefits of having
an annual valuation conducted. The most commonly cited
benefits of an annual valuation policy include the
following:
• Accountability and Performance-An annual valuation of a
privately-held firm enables the shareholders to see the
value that is being consistently created or destroyed by
the management of the firm in its execution of the
corporate strategic plan. Over time, if the executive
management of the firm consistently fails to create value
through the increase in the estimated fair market value of
the company's shares, the shareholders may seek to replace
the management team with a group more capable of executing
the strategy and creating value for the shareholders. In
addition, an annual valuation may enable the shareholders
to identify the need for substantial change to the
strategic plan if that plan consistently fails to create
the level of value anticipated. Overall, the annual
valuation promotes accountability and provides clear
performance measurement.
• Estate Planning Purposes-Many shareholders in
privately-held transgenerational enterprises have on-going
estate planning strategies aimed at protecting wealth for
heirs. As part of an estate plan, a shareholder may
periodically place shares into a family limited partnership
whose shares are then gifted to the shareholder's children.
A shareholder may also make gifts of shares to the
children each year for tax purposes. In order to
facilitate this, an annual valuation of the privately-held
enterprise provides the shareholders with part of the data
necessary for these estate planning purposes.
• Buy-sell agreements-In multi-shareholder firms, a
buy-sell agreement is an effective and practical means of
establishing how the buyout of other shareholders will be
conducted. Though many buy-sell agreements have a defined
method or process for establishing the value of the firm's
shares, an annual valuation sets a clear precedent for the
methodology used to establish the value of the shares. For
those firms that do not have buy-sell agreements in place,
annual valuations are a good way of avoiding (or at least,
tempering) disputes that may arise when a shareholder seeks
to sell his shares to the other shareholders. Whereas one
time valuations can be open to criticism of bias in favor
of one party or the other, an annual valuation tends to
limit this accusation as the methodology has been applied
consistently in previous years.
• Promotes Effective Communication-An annual valuation of a
privately-held firm is an effective means of communicating
value creation between the executive management, board of
directors, and the shareholders of the firm. The valuation
may be the catalyst for open discussion between the
management and the shareholders on issues related to the
strategic plan, succession plan, financial objectives,
return expectations, etc. In addition, an annual valuation
is a good way for the management and board of directors of
the company to provide value-added services for the
shareholders. This in turn can foster the creation of
goodwill between the management of the firm and the
shareholders, which may ultimately lower the firm's overall
cost of capital. The lower cost of capital may enable the
firm to invest in value-creating projects that create
long-term wealth for shareholders-projects that may have
been overlooked in the past as a result of a higher cost of
capital.
• Facilitate Banking-Many privately-held firms effectively
utilize leverage to invest in value-creating projects.
Often times, this leverage may exceed the credit available
based on the firm's fixed assets alone. In some cases, the
financial institution may be willing to lend against the
company's goodwill, which is identified in the process of a
formal valuation. The ability, then, of a privately-held
firm to borrow based on the value of the goodwill or the
value of the company's shares may expand the universe of
value-creating investment options available to the firm.
In addition, the annual valuation may establish a track
record of value creation which could be used to facilitate
a recapitalization of the firm, enabling management to
further seek value-creating projects, distribute funds to
the shareholders via special dividends, etc.
• Expands the Investment Options-Privately-held firms,
unlike publicly-traded counterparts, suffer from a lack of
liquidity and the inability to use the company's shares as
currency when seeking acquisitions or mergers. An annual
valuation that clearly establishes a trend in value
creation may enable the management of the company to use
the shares as acquisition currency for another
privately-held company. The annual valuation is also
beneficial in the shareholders' investment decision making
process with respect to maintaining the status of the
company or seeking liquidity through a merger or sale of
the company. The history of annual valuations may provide
the shareholders with a foundation for negotiation of more
favorable deal terms.
• Cost Benefit-Annual valuations may also provide the
company with cost benefits as compared to one-off
valuations performed every few years. Many valuation firms
charge reduced fees for the annual update to a valuation as
part of an ongoing valuation process for a privately-held
business. For example, suppose that Triumvirate
Industries, a privately-held company with $25 million in
annual revenues, chooses to have a valuation performed once
every five years. The valuation firm's fee is set at
$20,000 per valuation. However, suppose that Triumvirate
Industries has an annual valuation conducted. Whereas the
initial valuation fee may be $20,000, the subsequent annual
updates are $14,000. While the fee structure varies by
firm and by project, annual valuation updates typically
carry a lower cost than one-off valuations.
As can be seen from the previous discussion, there are a
number of benefits associated with a privately-held firm
instituting an annual valuation policy. While this is most
typical with large, transgenerational enterprises,
privately-held firms of all sizes may derive some benefit
from annual valuations-whether it relates to financing
purposes, estate planning, or the enlightenment of the
owners in how they are creating value within their firm.
Those firms that have been most successful in creating
long-term shareholder value and transgenerational wealth
have exhibited seven common characteristics, as previously
discussed. Those firms that have instituted annual
valuation policies have likely added value to the firm from
one of the previous seven benefits. In the end, the best
way of measuring the value that management has created for
the shareholders of a privately-held business, particularly
a transgenerational enterprise, is through annual
valuations conducted by an independent valuation
professional.
----------------------------------------------------
Robert M. Clinger III has strong experience in the fields
of business valuation and financial analysis, having earned
the Accredited Valuation Analyst (AVA) designation from the
NACVA and the Certified Business Appraiser (CBA) from the
Institute fo Business Appraisers. More information on
business valuations/appraisals may be obtained by visiting
Highland Global's website http://www.HighlandGlobal.com .
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