Family-owned business valuation is more art than science.

• Author: Smith, Harry J.
• Position: PRIVATEcompanies

The founding owners of a successful multi-location seafood restaurant chain turned their years of hard work into a nice nest egg by selling to a publicly held company. A win-win for both parties? Hardly. The restaurants were later sold back to the founders at pennies on the dollar. Smart people did the due diligence and believed a fair value was paid. So, what went wrong?

Many "private" businesses are family businesses, and some large publicly held businesses are family-controlled. In the tale above, the outcome might have been different if, when valuing the business the unique aspects of valuation of family businesses were considered.

Business valuation encompasses both science and art. Avoiding horror stories arising from overstated or unsustainable valuations requires lots of art, along with the science of valuation.

The "science" of valuation is grounded in academia and based on the application of three generally accepted valuation approaches: the income approach, the market approach and the cost approach. Each approach possesses specific characteristics which are more or less applicable for a given valuation scenario. The income and market approaches are typically relied upon for "going concern" business valuations; the cost approach generally applies to liquidation analyses.

The income approach discounts the free cash flows of the business to present value at a discount rate that reflects the total risk of the free cash flows to the investor, and normally assumes that the business will continue in perpetuity.

The market approach utilizes implied market multiples of financial statistics (revenue, free cash flow, total assets, etc.) observed in the public trading markets and publicly announced mergers and acquisitions. These implied market multiples are multiplied by the subject company's comparable financial statistics to provide indications of value. Such multiples, adjusted for "lack of marketability" and "controlling interest," can also be used to value family businesses.

The art of valuation is rooted in the experience of the valuation professional. Seasoned judgment must be applied to the various valuation approaches, the current M & A market, the investment perspective of the valuation (basis of interest as controlling vs. minority and marketable vs. non-marketable), and the company's value drivers (intangible assets, market positioning, barriers to entry, etc.).

Fair Value vs. Going Concern

In the family business arena...