For family businesses that have never had an external valuation, there is likely to be some confusion as to what the process involves. In this post, we give a brief walk-through of the valuation process, from engagement through to issuance of the final report.
The first step in the valuation process is preparing and executing an engagement letter. The engagement letter should clearly define several key components of the valuation, including:
- The subject interest to be valued (i.e., XX shares of XYZ Corporation, Inc.) – There needs to be absolute clarity on what will be valued. It is not uncommon for enterprising families to develop a rather elaborate structure of holding companies and operating businesses, and the engagement letter should clearly state what is being valued.
- The “as of” date for the appraisal – Any valuation conclusion pertains to a specific subject interest as of a specific date. Markets change, and the value of a family business is not static across time. For most engagements, the valuation report is issued after the “as of” date. In other words, there is nearly always some lag between the effective date for the conclusion and when that conclusion is rendered.
- The level of value for the conclusion – As we discuss at greater length in the following section of this whitepaper, family businesses have more than one value at any particular date, so the engagement letter should specify which level(s) of value are relevant for the valuation.
- The standard of value and purpose of the engagement – The engagement letter should indicate how the valuation is expected to be used and what the corresponding standard of value is.
- Fees – Most valuation engagements can be performed for a fixed fee. Occasionally, the scope of an engagement is sufficiently open-ended that the parties agree to calculate fees on an hourly basis. In either case, the engagement letter should spell out how fees will be calculated and when billings will occur.
Prospective clients naturally want to know how much a valuation will cost. Unfortunately, the answer to that question is that it depends on the complexity of the assignment. Most valuation professionals will ask to review a family business’s financial statements to help in preparing a fee quote. This allows the valuation professional to gauge the complexity of the analysis that will be required.
Valuation fees are ultimately a product of the estimated time required to complete the engagement and a targeted effective billing rate. Effective billing rate is a function of project complexity and the ability of the firm to leverage staff resources effectively to complete the valuation engagement efficiently. When comparing fee quotes, family businesses should keep this in mind. When presented with widely diverging fee quotes, one should ask if there are underlying differences in scope expectations or perceived complexity that need to be clarified.
Valuation is a data-intensive process. Concurrent with the engagement letter, most valuation firms will provide a preliminary information request. While potentially voluminous, the requested items are often ready to hand for family businesses, and include historical financial statements, financial projections, data on the assembled workforce, customer relationships, market segments, and product lines. In addition, clients often have access to industry-wide performance measures that are not readily available to those outside the industry. In short, the valuation professional will seek to collect the same sorts of data on the subject company that a potential investor would.
Upon receipt of the requested information, the valuation firm will perform diligence procedures, including relevant economic and industry research and analysis of the subject company’s historical and projected financial performance. The diligence phase of the engagement culminates in an interview with senior management of the family business. The purpose of the management interview is to help the valuation professionals identify and articulate the underlying narrative of the company: what makes this family business tick, and why is it valuable?
The heart of the process is the application of valuation methods under the asset-based, income, and market approaches. Each approach seeks to answer the valuation question from a unique perspective.
- What are the current market values of the business’s assets and liabilities? This is the key question underlying the asset-based approach. It may involve assessing whether there are assets or liabilities that do not appear on the company’s balance sheet and evaluating whether there are assets having current market value different from that recorded on the balance sheet (such as real estate that has been owned for decades).
- What are the expected future cash flows of the family business, and how risky are those cash flows? This is the income approach to valuation, and it involves a careful analysis of the historical earnings of the family business, as adjusted for unusual or nonrecurring items, and the outlook for the economy, relevant industry, and the family business itself.
- What can be inferred about the value of the family business from transactions in reasonably similar businesses? This is the essence of the market approach, and it involves searching for and analyzing comparable public companies and/or transactions involving comparable private companies.
In applying these methods, the valuation professional seeks to develop reasonable inputs and consider prevailing market conditions at the “as of” date for the valuation.
Draft Report Review
Concurrent with performing the analysis, the valuation firm will prepare a draft valuation report which describes the company, relevant industry and economic trends, valuation methods applied, and inputs used. The client should have an opportunity to read this document in draft form. This draft review is a critical step in the valuation process, helping to ensure there have not been any misunderstandings or miscommunications that would undermine the credibility of the conclusions in the valuation report.
Clients should read the draft report carefully to assess whether the valuation firm developed a balanced and informed view of the industry and the company. Clients should be able to recognize their company in the valuation report. If they don’t, the draft review process should allow them to discuss those concerns with the valuation analyst.
Issuance of Final Report
Once the draft review process is concluded, the valuation firm will issue a final report. The final report should include the attributes of the engagement from the engagement letter and a clear description of who is entitled to use the report and for what purpose.
Billing practices vary and should be detailed in the engagement letter. Many valuation firms request a retainer at the beginning of the engagement and invoice for the remainder of the professional fee at the end of the engagement, either upon completion of the draft report or issuance of the final report.
In the normal course, family business leaders should anticipate that the valuation process described in this section should take six to eight weeks to complete. Most valuation firms are able to adjust as needed to accommodate reasonable deadline requests so long as they are communicated to the valuation firm during the engagement process. Prompt responses to information requests and follow-up questions help to keep the valuation process on track. Regular communication between the client and the valuation firm is the most important factor in meeting deadlines for project completion.
Mercer Capital has worked with hundreds of family businesses over the last 40 years. If you think your family business needs a valuation but don’t know where to start, give one of our professionals a call, we’d be happy to help discuss your needs today.
This week’s post is an excerpt from section 2 of What Family Business Advisors Need to Know About Valuation whitepaper. If you would like to read the full version click here.