What are the different methods used for Family Business Valuation?

There are different ways to figure out how much a family business or other type of business is worth. Traditional methods of valuing businesses have relied on a company’s profits or asset worth. 

For many family business owners, valuing their company is costly. Unfortunately, both of these ideas are wrong. Family business valuation and succession planning should be a process, not always an official written report. To be useful, it should be part of the yearly business strategy process, not just after an event. 

So, what are the effective methods used to value family business? Are there any challenges to be mindful of? Let’s learn everything in this article.

Family business valuation 

Usually, a family-owned business operates differently from a large public company. Collaborating with one another can bring out both the positive and negative aspects within families. Valuation experts consider various factors when assessing the value of these entities. 

So, let’s start by discussing the fundamentals of family businesses.

Understand family business

If you run a family business, your business’s future depends on many things, and your firm is likely to be the most valuable asset in your estate in terms of estate tax and business succession planning. If you want to start passing the wealth down to your loved ones (children, grandkids, etc.) or other beneficiaries, getting your business evaluated as soon as possible could be prudent. 

Family company owners preparing for succession must recognize that business distribution should be fair. However, such a feeling of justice does not always result in a 50-50 split! The first step in valuing your firm’s assets, and before deciding on any succession or gifting plans, you should be sure of this to avoid giving an unintended portion of the company to someone who isn’t expecting or interested in receiving it. 

It is wise to consult an experienced family business valuation and financial advisor to review your long-term goals.

Why do we need a valuation for family business?

The family business valuation is important in many strategic and operational choices. Let’s look at them one by one.

• It provides an accurate market value that guarantees equitable transactions when purchasing or selling equity to employees or selling to other relatives after retirement.
• It’s very helpful for planning for the future, like giving shares to children and reducing the chance of paying estate taxes. 
•  An accurate family business valuation assists both buyers and sellers in understanding the value of the firm, making it simpler to agree on a reasonable price.
• A sound family business valuation is the basis of phantom stock schemes, which provide proper recognition and compensation for non-family key management.

What factors affect the valuation of a family business?

Some things need thorough consideration before you begin to value a family business.

What should be valued? Why do you need a family business valuation? When should the value be estimated?

If these requirements are met early in the planning process, paying for a formal family business valuation analysis may not be necessary. 

When managing owners know which factors affect the value the most and which affect it the least, they can make better decisions about who will take over and how to transfer ownership.

Expertise is necessary when valuing a family business. For example, it is much harder to sell the stock in a family business than it is to sell the stock in a public company. A family business is less flexible and usually worth less based on many factors, such as pre-tax income, cash flow, owners’ profit, etc. 

There are adjustments for lack of marketability when assessing the value of shares held by family members or other closely held businesses. It becomes intuitively clear when one considers why firms go public: to establish a market, raise cash, and sell the founders’ interests.

Family business valuation methods

Family business valuations require understanding and implementing various methods to see what works. Here is a list of approaches to get you started on the valuation process.

Income-Based Methods

The income valuation method calculates the current value of the family business’s predicted future cash flows. This approach determines the company’s worth by discounting the cash flow projections for the future at a suitable rate to get the current value of those projections.

Example for Income Based Method:

Let’s say we have a family business with 100,000 outstanding shares and a market price per share of $50. 

• Calculate the Market Capitalization:
  • Market Capitalization = Number of Outstanding Shares * Market Price per Share
  • Market Capitalization = 100,000 shares * $50/share
  • Market Capitalization = $5,000,000
• Adjust for Control Premium: Let’s say a control premium of 20% is applied to reflect the additional value of having control over the company.
  • Adjusted Market Capitalization = Market Capitalization + Control Premium
  • Adjusted Market Capitalization = $5,000,000 + (20% of $5,000,000)
  • Adjusted Market Capitalization = $5,000,000 + $1,000,000
  • Adjusted Market Capitalization = $6,000,000

So, in this simplified example, the family business’s valuation using the Market Capitalization Method would be $6,000,000.

Asset-Based Methods

You get its net asset value when you subtract the family business’s total bills from its assets. This is what the asset-based method of family business valuation is all about. This approach works best for companies with many physical assets, such as property, equipment, or stock. 

Example for Asset based Method

Let’s consider a family-owned business operating in real estate.:

• Calculate the Value of Assets: Determine the total value of the business’s assets. Let’s say the business owns properties, land, and equipment with a total value of $10,000,000.
• Subtract Liabilities: Subtract any liabilities, such as loans or mortgages, from the total asset value. Let’s say the business has liabilities totaling $2,000,000.
• Net Asset Value = Total Assets – Total Liabilities
  • Net Asset Value = $10,000,000 – $2,000,000
  • Net Asset Value = $8,000,000

So, in this example, the family business’s valuation using the Asset Based Method would be $8,000,000.

Market-Based Methods

To determine the family business valuation’s worth, the market method compares it to similar companies that have already sold or are on the market. This technique examines similar organizations in the same market and sector to estimate the subject company’s worth. The idea is that these companies will have similar traits.

Example for market based method:

Let’s consider a family-owned retail business and its valuation using a market-based method, specifically the Comparable Companies Analysis:

• Identify Comparable Companies: Identify three  publicly traded companies in the same industry as the family business: Company A, Company B, and Company C.
• Gather Financial Data: such as their market capitalizations and financial ratios.
• Calculate Valuation Multiples: Let’s assume the average P/E ratios for the comparable companies are as follows:
  • Company A: P/E ratio of 15
  • Company B: P/E ratio of 18
  • Company C: P/E ratio of 20
• Apply the Multiple to the Family Business: Apply the average P/E ratio of the comparable companies to the earnings (net income) of the family business to estimate its valuation.Let’s say the family business has a net income of $500,000.
  • Estimated Valuation = Net Income * Average P/E Ratio
  • Estimated Valuation = $500,000 * (15 + 18 + 20) / 3
  • Estimated Valuation ≈ $500,000 * 17.67
  • Estimated Valuation ≈ $8,835,000

So, in this example, the family business’s valuation using the market-based method (Comparable Companies Analysis) would be approximately $8,835,000.

Discounted Cash Flow (DCF) Method

It is possible to estimate a company’s worth by projecting its future cash flows and then discounting them to the present using a discount rate that accounts for the opportunity cost and risk associated with the investment. This technique is the discounted cash flow (DCF) approach. 

Example for Discounted Cash Flow Method:

Let’s say we have a hypothetical family business that operates a bakery and it generates annual cash flows. 

• Projected Cash Flows:
  • Year 1: $100,000
  • Year 2: $110,000
  • Year 3: $120,000
  • Year 4: $130,000
  • Year 5: $140,000
• Discount Rate: Let’s assume a discount rate of 10%. 
• Calculate Present Value: Using the discount rate, you can calculate the present value of each year’s cash flows. The formula for present value is:PV = CF / (1 + r)^nWhere:
• Applying this formula to each year’s cash flow, we get:
  • Year 1: $90,909
  • Year 2: $90,909
  • Year 3: $90,158
  • Year 4: $88,792
  • Year 5: $86,929
• Calculate Terminal Value: 

Terminal Value = Final Year Cash Flow * (1 + g) / (r – g) where r is the discount rate and g is the perpetuity growth rate.

Let’s assume a perpetual growth rate (g) of 3%. Using the cash flow projection for Year 5 ($140,000) and the discount rate of 10%:

Terminal Value = $140,000 * (1 + 0.03) / (0.10 – 0.03)

              = $2,060,000

• Discount Terminal Value: Discount the terminal value back to its present value using the same discount rate. 

Terminal Value PV = $2,060,000 / (1 + 0.10)^5 = $1,279,098

• Calculate Total Present Value: Sum up the present values of the cash flows and the terminal value to get the total present value:
  • Total PV=$90,909+$90,909+$90,158+$88,792+$86,929+$1,279,098
  • Total PV=$1,726,795

Hence, the value of the family bakery business is approximately $1,726,795.

Challenges in Family Business Valuation

Family-run businesses rank among the most prominent and prosperous in the world. These companies, however, aren’t always without challenges. Expert valuation specialists realize family-owned firms’ frequent challenges and alter their methods to evaluate their value to third-party purchasers and sellers in arm’s length transactions. Here are a few examples of such challenges.

Family Dynamics

Family relationships and disputes may have a substantial influence on value. It can be hard for family members to agree on how much the business is worth because they have different interests, personal views, and expectations.

Family members should talk to each other freely and honestly, get professional help, and try to keep their attention on what’s best for the business to lessen the effects of these disagreements.

Lack of Market Data

Family companies frequently lack openness and information, making the appraisal process more difficult. There is a chance that financial records are missing or outdated, which makes it hard to figure out how the company is doing financially.

Working with a professional appraiser is important in these situations because they can help you get the information you need and give you an accurate appraisal.

Management Issues

Many family business owners prefer to rely on their intuition and employees’ confidence rather than establishing explicit procedures in writing. It’s also common for family business owners to prefer conservative business tactics and non-financial goals, which can slow growth and cause smaller profits.

When determining the value of controlling interests, specialists consider the hypothetical purchase price of a family-owned business by an unrelated third party.

Furthermore, many family firms’ free management style can result in inadequate internal control mechanisms and, in certain cases, fraud. Valuation professionals consider this extra risk element and keep an eye out for symptoms of fraud.

Financial Complexity

Some business owners choose to employ relatives because they are more reliable. Still, many others do so out of duty or because they want to ensure the company will continue in the family.

When appraising family-owned businesses, business appraisers objectively examine whether family members are competent for their jobs and if their remuneration is appropriate. Upper management may sometimes wish to reduce headcount by integrating family jobs when dealing with a potential buyer. Thus, family business valuation professionals frequently increase cash flow to account for the cost of hiring relatives.

Trust Eqvista for Accurate Family Business Valuation!

Successful family business owners know how to grasp their company’s value by learning why it’s important, how to choose the right valuation methodologies, and how to deal with all the variables and obstacles that come with it. 

Eqvista provides trustworthy company valuations for use in family dispute settlements. Our service offers all the tools and information you need to determine your company’s value, ensuring an honest and transparent settlement. Above all, you get accurate valuation reports in minutes. Talk to us immediately to learn how to have your family business valuation with reliable results!