The Importance of Business Valuation

Understanding the true value of your business is crucial for its overall health and well-being, as well as for planning your exit strategy. Failing to comprehend your company's worth could lead to unpleasant surprises down the line. However, determining the true value of your business can be challenging if it's not publicly traded.

Understanding Business Valuation

A business valuation is an independent appraisal that assesses calculates the worth of your company. This can be done in many ways, but it is commonly based on expected cash flows and other transactions of similar companies, if they exist.

The business valuation report is more than just a number, though. It is a powerful asset that provides insight into the inner workings of your company. The sooner you engage in a valuation, the more time you’ll have to strategically optimize your business’s “levers of value” and more successfully achieve your goals – i.e., maximize your company’s value.

Regardless of the stage your business is in or even if you do not foresee a transaction triggering event in your near future, a business valuation will help you be prepared.

What do we mean by transaction triggering events? Here are some examples:

Owner/employee quits
Owner/employee is fired
Owner retires
Owner wishes to sell their stock
Owner becomes disabled
Owner passes away
Owner(s) divorce
Company bankruptcy

When these types of events happen, they can cause a shift in your business and its future. It is amazing how quickly your plans for your business may change when affected by these types of events. This is why we recommend that you consider including a well-defined valuation process in your governing documents.

This is especially important for family-owned businesses. These types of companies have spent years building their organizations from the ground up. While many owners believe they know the worth of their business, it is important to have a third-party appraisal to provide a true value of your company, as well as give steps to help you prepare for future growth or exit.

For family businesses that include a mix of owners that are 1) involved in operations, 2) family members with ownership but not involved in the company, and 3) non-owner family members working in the company, obtaining a business valuation ensures ownership in the business is facilitated in a fair way to all family members and stakeholders.

The Importance of Conducting a Business Valuation Early and Often

Choose a qualified appraiser now, rather than when a triggering event has already occurred.

It is beneficial to have the appraiser conduct periodic valuations of your business (for example, every year or every two to three years, depending on the growth and changes among your business). This enables all stakeholders to know and understand the value of your business throughout its lifecycle.

Choosing an appraiser early has several benefits:

The valuation process will be known by all stakeholders at the outset.
Because the appraiser must interpret the ‘words on the pages’ in conducting the initial appraisal, issues regarding lack of clarity or terms can be resolved. As a result, subsequent appraisals should be less time-consuming and expensive.
Appraiser’s knowledge of the company and its industry will grow over time.
Stakeholders should gain confidence in the process.
Stakeholders will likely maintain a general idea of the current value.
All stakeholders should know what will happen when a triggering event occurs, rather than scrambling to put together a game plan.

The Impact of Business Valuation on Family-Owned Businesses

While the goal for many family-owned businesses is to transition to the next generation, this might not always be the case. According to many studies, about 75% of family businesses do not have a succession plan in place. And while 70% of family businesses hope to pass their legacy to the next generation, only 30% successfully does so.

Learn more about what happens when next-generation succession isn’t an option.

This is why an independent valuation is essential for family-owned organizations. A formal valuation that takes place on short notice does not give leaders adequate time to protect, let alone influence, the value of their company. When done early and proactively, family businesses can work to solve management and operational issues that could potentially hurt a future sale or transition of the organization.

Even if a family-owned business does plan to transition to the next generation, it is important to know the worth of the organization. This way, family succession can come from a place of fairness as owners decide how to divide ownership for the next generation, including both active and passive stakeholders.

A business valuation can be performed independently, but it can also be included in larger succession planning conversations. Make your business valuation part of a comprehensive, strategic planning process that not only tackles ownership transition questions, but also leadership selection and development, and other family governance best practices.

The Impact of Discounts on Business Valuation

As part of an overall wealth planning strategy, many people will gift shares of stock to family members. When valuing a noncontrolling interest in a business (someone who owns part of a company but doesn’t have control over it), it is typical of a valuation analyst to apply discounts, which are more technically known as a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM). Noncontrolling interest discounts can be helpful in certain tax planning strategies when the end goal is to transition ownership to the next generation.

A DLOC is the amount of money or percentage that is taken off the value of a business to show that the person who owns part of it doesn't have control over things like decision-making or distributions.

When someone holds a noncontrolling interest in a business, they lack the ability to:

Implement business and operational characteristics.
Appoint and remove management.
Control the timing and amount of distributions.
Put the entity’s assets to their highest and best use.

In other words, the value of a noncontrolling interest is discounted because it does not possess the full benefits of control.

A DLOM is the amount of money or percentage that is taken off the value of a business to show that it takes longer to sell part of a private company than it does to sell part of a public company. In the valuation world, we refer to liquidity as “cash in three days,” which is expected when selling publicly traded stock. However, when it comes to selling private companies, it takes much longer than three days to receive cash, which is why a DLOM is appropriate.

A noncontrolling owner’s primary way to receive a return on their investment is through distributions of profits, which are primarily dependent upon the company’s financial stability.

Going back to the concept of “cash in three days,” owners will also look at the obstacles they could encounter if they decide to sell in the future, which could potentially be affected by the company’s transfer restrictions and redemption policy.

Not only are discounts helpful for transitioning family-owned businesses to the next generation, but they are also extremely important to understand when negotiating transactions with outside investors. In fact, if you are planning to sell your business, there is a good chance you might encounter these discounts. It is important to understand them so you know what price you can realistically expect from the sale of your business.

Other Items to Consider

Other items to consider in a business valuation include:

How are shares of your company purchased or funded? Where will the money come from?
Who buys the shares? Other shareholders? The company? A combination?
If the company has life insurance policies, is the coverage adequate?
Are there other financial resources available to buy the shares?
What are the terms of the transaction? (down payment, interest rate, security, etc.)
Are there any restrictions on share payments under the company’s loan agreements?