Do you know the value of your family business?
It wasn’t raining when Noah built the Ark (Anonymous)
Shareholder value is a phrase which is often mentioned in discussions involving business management issues. At one end of the spectrum, listed public companies consume tremendous resources focussing on recording, explaining and improving value to shareholders; such value is displayed for all to see each day in the company’s share price. A public company director’s fortunes can depend on how successful the company is, or is not, in its attempts to add to that value.
On the other hand, it’s not uncommon for a family-owned business to go about the day to day operations with little or no regard to the value of the business, let alone what could be done to improve that value. One reason for this is that there is no perceived need to know what the value is. This occurs particularly when the current owners plan to pass ownership to the next generation of the family; that is, no external sale is being contemplated. Unfortunately, on many occasions such a transfer never eventuates, often due to family disputes, many of which actually occur over valuation issues.
Even where the family business owners are open-minded about the possibility of selling to a third party, they are typically under-prepared when such offers come along; the best price will only be obtained if prospective buyers can clearly see an established pattern of performance, and that appropriate management and systems have been in place for a reasonable period of time, before the due diligence begins. These issues need to be addressed for a significant period beforehand, ideally three years or more, in order to get the business sale-ready.
A number of the issues that family businesses commonly struggle with can have a negative impact on value, for example:
- Lack of succession planning for directors & CEO
- Lack of independent Board members
- Family members inappropriately employed in senior positions
- Systems & procedures not properly documented
- Lack of robust financial reporting
- Inadequate family/business governance eg family council & family charter.
Another relevant aspect is that directors of a family business have a legal duty to act responsibly and protect the company’s assets, which would include a duty to ensure that the value of a business is not allowed to dissipate due to the director’s inaction. At the very least, directors are charged with the obligation to ensure that shareholder value is not damaged, and is preserved and enhanced as much as possible for the benefit of the current shareholders, and where those family shareholders regard themselves as custodians, the next generation of owners.
How is value arrived at?
While there are many different valuation methodologies available, for profitable businesses with a reasonable track record, the capitalisation of maintainable earnings is a commonly used methodology.
This is a 3-step process involving:
- 1Calculation of a dollar amount of future maintainable earnings (FME), which is normally an average of current and anticipated net profits, adjusted for abnormal & non-recurring items
- Identifying an appropriate capitalisation rate, ie a multiple
- These two factors are multiplied to obtain the dollar value of the business.
While calculation of FME is rarely straight forward and can involve some degree of subjectiveness for a valuer, selection of an appropriate multiple generally tends to be more problematic, and in the case of family business, some common deficiencies tend to crop up which can suppress the multiple and therefore, suppress value. The multiple arrived at will have an inverse relationship to the perceived risk of investing in the business; that is, the higher the risk, the lower the multiple, and vice versa. The aim of a family business owner should therefore be to identify as clearly as possible those factors which can be improved enough to reduce the risk to a potential investor. Factors which influence the multiple can be classified into four broad categories:
- Products & distribution – does the business have time-tested products? Is the business reliant on one or two major customers or suppliers? Do contractual arrangements exist with key customers & suppliers? Is the business operating at full capacity or does a ‘blue sky’ element exist?
- Management – is there an effective Board of Directors? Does the Board and management team include non-family members where appropriate? Is there a succession plan for key management positions? Are job descriptions properly documented?
- Market position – how much of the market does the business control, and what is the scope to increase? Can a separate (saleable) value be attributed to existing brands? How susceptible is the business to factors beyond its control, such as exchange rate movements? Is there a threat of offshore competition? Are there merger or takeover opportunities?
- Systems – does the management information system produce relevant, accurate and timely reports? Are the financial statements audited? Are all relevant systems properly documented and regularly reviewed and updated? Is there a properly documented strategic plan? Is there a properly documented business recovery plan?
The two areas which family business tend to struggle with most are management and systems. A 2009 survey conducted by Family Business Australia found that over two-thirds of family-owned businesses do not have a formal board of directors; only four percent of family-owned businesses have a non-family director; and only three percent of family-owned businesses have a non-family CEO. In addition, less than 20 percent of family-owned businesses have a succession plan for the CEO, and only eleven percent have a succession plan for other senior management positions. In relation to planning, the survey reported that 66 percent of family-owned businesses do not have a business recovery (including disaster recover) plan. These are the areas which family business owners would be well advised to invest their initial efforts to improving, in order to have the most immediate positive impact on value.
Directors of family business should conduct a valuation exercise internally or engage the assistance of a business valuation specialist if required. This could identify which of the key factors have the most potential impact on the valuation multiple. This valuation should then be periodically revisited, if not by way of a full re-calculation, then by assessment of whether improvement of the relevant key factors has been achieved. The process of examining the key factors would necessarily focus attention on those weaknesses which the business should be addressing in any case, and the directors would be able to sleep more soundly at night, having gone further down the path to satisfying their legal and moral obligations to the company’s shareholders.