It’s a family affair
Valuing family businesses

Attorneys familiar with family-owned enterprises know that these businesses are somewhat quirky and often require client-handling finesse. The same holds true for valuation professionals who appraise family businesses, especially those that are smaller. Let’s take a closer look at the nuances involved.

Ask the right questions - Here are some key questions valuators should ask when valuing these entities:

Are family members on the payroll? - The terms “family business” and “nepotism” often go hand-in-hand. Although some business owners hire family members because they’re perceived as more trustworthy, many hire relatives out of obligation or to satisfy a desire to pass the business on to their offspring.

When valuing family-owned entities, business appraisers need to objectively consider whether family members are qualified for their positions and whether their compensation is reasonable. In some cases, management may want to consolidate family members’ positions and use fewer people to perform their duties. As a result, valuators often make an upward adjustment to cash flow to reflect the excess expense of employing relatives.

But the reverse may also be true. Some family businesses overwork or underpay related parties. This is true for business owners whose passion for their work and desire to succeed lead them to work exceptionally long hours.

\When evaluating a related party’s compensation, valuators should look beyond the relative’s base pay. For example, they must also adjust for payroll taxes, benefits and extraneous perks. Perks may include such things as allowances for luxury vehicles, country club memberships or loans at below-market interest rates.

Do other related-party transactions exist? - In addition to employing relatives, family-owned businesses may engage in other transactions with family members, such as rental contracts, supply agreements and related-party loans. Valuators should inquire whether these transactions exist and are at arm’s length.

In many instances, related-party transactions are “sweetheart deals” that require adjustments to the company’s income stream. (See the sidebar “The ins and outs of related-party transactions.”)

Is the management style casual? - Family business owners tend to have a more personal management style that favors gut instinct and trust over formal written policies. Further, many family business owners favor conservative business strategies and nonfinancial goals, which often lead to slower growth and lower profits.

Particularly when valuing controlling interests, valuators should consider how much a family-owned business could be worth in the hands of an unrelated hypothetical buyer.

In addition, a lax management style characteristic of many family businesses can lead to weak internal control systems — and even fraud. Valuators should take this additional risk factor into account and be on the lookout for the warning signs of fraud.

Is a key person discount appropriate? - Although family businesses often rely heavily on one individual, not every family-owned entity warrants a key person discount. These discounts are relatively rare and reserved only for those businesses that would suffer a significant monetary loss if the key person left the company.

The typical approach to quantifying a key person discount involves estimating the company’s monetary loss if the key person were to depart. Others estimate a percentage discount after considering several factors, such as the key person’s skills, the company’s financial position, employee turnover and management structure.

Owners can take preventive measures to safeguard their companies, such as requiring key managers to sign employment contracts. Family business owners may also consider implementing a viable succession plan or take out a life insurance policy on the key person’s life, listing the company as beneficiary. Such risk minimization techniques generally offset any key person discount.

Take everything into account - To ensure that their value estimates are as accurate as possible, these are just a few important factors valuators must take into account as they analyze family-owned companies’ operations. Yes, valuing family businesses can be tricky — but with an understanding of the appropriate considerations, not impossible.

Sidebar: The ins and outs of related-party transactions

Suppose a struggling family-owned manufacturer buys discounted raw materials from a supply company his wealthy uncle owns. It’s unlikely that the manufacturer’s uncle would be as generous in his pricing to an unrelated purchaser.

To best reflect this hypothetical business’s fair market value, a valuator would have to reduce the subject company’s cash flow to the extent that the related supplier’s prices are below market rates.

Conversely, if the wealthy uncle sold his supply business, an unrelated purchaser would probably increase the prices charged to the seller’s struggling nephew. Therefore, if valuing the hypothetical uncle’s business, an appraiser would probably adjust the company’s income stream upward to reflect the higher prices a new, unrelated owner would likely charge the nephew’s business.

On the other hand, the uncle’s business may be recognizing below-market-level revenue on sales to the nephew that couldn’t bring a higher price without putting the already struggling company out of business. The point is to take everything into account — even factors outside the business being valued.