Introduction
There are various methods and approaches for valuing family and other types of businesses. The value of a business is traditionally based on the earnings it generates or the value of its assets.
The earnings-based approach is used in a going concern context where it is assumed the business will be able to carry on its activities and potentially increase its earnings. The asset-based approach is generally used when the business does not generate an adequate return on the capital invested by its shareholders. The required return depends in particular on the risks associated with the industry and the business to be valued.
Asset-based methods
Adjusted Book Value : The adjusted book value method is sometimes used to value companies that own shares of the family operating company. This method involves restating each asset and liability in the books to reflect their fair market value at the valuation date. Investments in profitable operating companies are valued based on earnings whereas the others are valued at their net realizable value, i.e. net of any latent income taxes.
Liquidation Value : If a family business is not very profitable or does not generate an adequate return, the highest price (fair market value) is its liquidation value, which requires determining the net amount the shareholders will realize after disposing of the assets and paying all the liabilities. The realization value takes account of the costs related to the disposition (commissions, fees, corporate income taxes, etc.). Costs incurred during the liquidation period, job termination payments and lease cancellation penalties also have to be included in the calculation.
Earnings-based methods
This section discusses the most frequently used earnings-based methods for valuing family businesses, i.e. capitalization of maintainable net earnings and capitalization of discretionary net cash flows (for the shareholders).
Capitalization of Maintainable Net Earnings : This involves determining the net maintainable earnings and capitalizing them at an appropriate rate (multiple). Surplus assets, i.e. assets not necessary to the operations, are added at their net realizable value. This approach is based on the premise that a seller could remove these assets before selling the family business or would require compensation for them.
Capitalization of Discretionary Net Cash Flows : This method is used when there are significant differences between the amount of depreciation and the annual investment required to keep the family business going. It differs from the preceding method in that it uses cash flows instead of earnings. Income taxes are also treated differently. Under this method, the discounted value of the income tax savings on the undepreciated capital cost (UCC) at the valuation date is added to the capitalized value in order to compensate for the income taxes calculated on the cash flows instead of earnings.
Step 1: Determine maintainable net earnings/discretionary net cash flows: : In determining the maintainable net earnings/discretionary net cash flows of a family business, other than non-recurring expenses, management compensation often has to be adjusted to reflect what a purchaser would have to pay in the open market for similar functions because such compensation generally includes a number of items, such as base salary, bonuses, dividends and expense accounts. A number of family businesses also pay the cost of any life insurance premiums for their owner/managers. Such expenses have to be eliminated from maintainable net earnings/available net cash flows because they are discretionary expenses.
Step 2: Determination of rate of return (multiple) : The earnings (cash flow) multiples are determined by using the rates of return on low-risk investments (e.g. Canada long-term bonds) as a starting point. The valuator then has to add a number of risk premiums to this rate to arrive at an overall rate of return that a prudent investor should require for investing in a family business. Risk premiums cover risks relating to the ownership of corporate shares, the size of the company and the company’s actual business (competition, clientele, employees, regulatory issues, etc.).
Multiples of public companies in the same industry can be used to determine the appropriate earnings (cash flow) multiples for the company to be valued. However, they have to be adjusted to take account of the fact that there are important differences between “comparable” public companies and family businesses.
Particular family business valuation problems
Key person : The success of a family business often depends on the efforts of a single individual – the owner/manager. The individual generally works in a highly specialized field of activity that requires experience, holds a number of positions in the company or maintains close relations with its customers.
From a valuation perspective, the impact of such individuals can be reflected by means of a discount on the overall value of the company’s shares, a discount on maintainable net earnings/discretionary net cash flows or an adjustment of the multiples.
Among other things, the importance of the key person depends on:
– The ability and the time required to find another individual who can eventually take over the responsibilities of the key individual; and
– The compensation paid to the key individual compared to the compensation that would have to be paid to a replacement.
A number of studies on this question since the 1970s show that the discount for a key person has been decreasing steadily and is now between 5% and 10%. A possible reason for this phenomenon is that small family businesses have increased their ability to retain management capabilities.
Shareholders’ Agreement : Family members who own shares often prepare an agreement. Difficulties in interpreting such agreements lead to problems in valuing the shares.
a) Clauses concerning the valuation or fixing the price of the shares may disadvantage one of the parties when there is a transaction. Using a predetermined formula may not be suitable to particular circumstances, which may result in the value of the company being overstated or understated.
b) The defined price or proposed value in the agreement can lead to interpretation difficulties. If the term “fair market value” is used, the possibility of a minority interest discount or a discount for a weak negotiating position has to be considered when valuing the minority interest.
When valuators are faced with such problems, do they have to consider the shareholders’ agreement in valuing the family business?
From a tax perspective, Information Circular 89-3 sets down the conditions for a shareholders’ agreement to be determinative in establishing the value of the shares if the agreement is binding on non-arm’s length parties. The Circular states that :
” The stipulated price or formula price in the agreement provides full and adequate consideration, and represents the fair market value of shares determined without reference to the agreement at the time it is executed. “
Minority Interests : Family businesses frequently have shareholders who own minority interests. In valuing such interests, it is recognized that the value should be discounted on a prorated basis.
To quantify (subjectively) the minority discount, the following factors, among others, have to be considered – the size of the minority interest, the number of shareholders, whether there are potential purchasers for the minority interest, the degree of influence the minority shareholders have, etc.
Canada’s courts have considered the minority interest discount issue in a large number of cases where control was exercised by a group or a family. There has been no consistent position (e.g. a systematic rate of 30%) in quantifying the discount.
The tax authorities take the position that when a family controls a corporation, the value of the shares of each family member or family group has to be determined proportionally. Information Circular 89-3 discusses the question of control by a family group in detail.
Conclusion
The value of a family business has to take into consideration its particularities, which requires professional judgement and common sense. A reasonable effort should be made to support the fair market value used for a transaction because the tax authorities may take a close look at it.
