Family business transfers are complicated because there is a lot at stake – money, family relationships, and the future of the business. One of the most difficult things to consider in a family transfer is the valuation of the business, commonly referred to as “the number,” meaning the price that will be placed on the family business when transferring it from the first generation (G1) to the second (G2).
When embarking on this journey, many family businesses mistakenly hire an outside valuation firm to prepare a business valuation. A formal valuation report for this purpose is unnecessary and expensive, because it does not address the complexity involved in establishing the number for the family transfer. Such valuations are normally prepared on a fair market value basis, which may not address the unique issues involved in assessing a family transfer.
We find valuation in family transfers to be far more complex. For that reason, families in transition need valuation advice, but not necessarily a formal valuation. The ultimate price is a triangulation of three factors:
- What is G1’s number? In other words, what is the amount that G1 needs or wants? Often this number is not the true value of the stock but a reflection of G1’s personal retirement picture. In many cases, G1 leaders do not necessarily want what they can get; they only want what they need because they have a duality of motives – they want to be secure in retirement and for their family to succeed with the family business.
- What is a reasonable range of values for the business? Without a 40-page report, gaining some valuation advice to establish a reasonable range is often all that is needed to help a family set some parameters for their discussion.
- What is the company’s capacity to handle a transaction? What can the company afford from a balance sheet and cash flow standpoint? No matter the true value of the business or the amount that G1 wants or needs, the most important consideration is what the company can afford because the company is normally the source of the cash flow to fund a payout. This is G2’s principal concern, as they will be the ones left to run the company after generating the cash needed to pay the G1 buyout.
Valuation of private companies is never simple, and the process is more art than science. Establishing “the number” in a family transfer is a far more complex exercise because of the unique relationships that exist when family members work together. The buyer and seller are related and both have motives beyond simply the price of the transfer.
To be successful in intergenerational transfers, family business owners must recognize the complexity of the financial elements of the transaction. Simply getting a valuation will not do. Families need a business and financial advisor to manage the complexity of the transaction and establish a valuation for the family transfer based on G1 needs, typical valuation theory, and the company’s financial capacity.
Mario O. Vicari can be reached at Email or 215.441.4600.