In last week’s edition of the Family Business Director, we reviewed six valuation principles for family business directors to keep in mind when developing valuation estimates. As family business directors, it is important to understand not just the “how” of maintaining an accurate estimate of the value of your family business but also the “why.”

In this week’s post, we have compiled a selective list of reasons why it is essential for both family shareholders and family business directors to know what the family business is worth (even if the family has no intention of selling).

Having access to an accurate valuation estimate helps…

…shareholders better manage their own personal finances. Understanding the value of all your assets (liquid and illiquid) is essential to prudent personal financial planning and decision-making.

…facilitate intra-family transactions. Even if the family does not plan to sell the business, certain shareholders may desire to transfer shares (through gift or sale) to other family members. An accurate, up-to-date valuation helps minimize the likelihood that intra-family transfers will unintentionally create economic winners and losers within the family.

…prepare the family for unsolicited acquisition offers. Capable and motivated buyers can offer to buy the family business even if it is not for sale. When an offer like this comes in, deciding how to respond often becomes emotionally charged. An assessment of value performed by a third party can help ease some tension by ensuring the board formulates a rational and measured response to any unsolicited acquisition offers.

…establish realistic expectations of future returns among family shareholders. Family shareholders are entitled to a future return on their investment in the family business. Establishing the expected return is important for both shareholders and the managers and directors of the family business. For shareholders, the expected return provides an important benchmark for evaluating the performance of their investment over time.

For managers and directors, the expected return is a critical component of weighing shareholder distributions against potential available investments. Family capital will eventually flow to its most productive use, whether inside or outside the family business, and the expected shareholder return is a key component of capital allocation for the family.

For family business directors in particular, accurate valuation estimates can support…

…evaluating your family business’ distribution policy. Shareholder returns come in two forms: distribution yield and capital appreciation. Cash flow distributed to family shareholders cannot be reinvested in the business to fuel growth, and cash flow distributed to family shareholders is no longer at risk of being lost in the family business. Given these tradeoffs, there is no single “right” dividend policy for a family business. While individual shareholders may disagree with your family business’s dividend policy, it can be reassuring to family shareholders if there is a clear consideration of required shareholder returns, available investment opportunities, and shareholder preferences.

…assessing capital budgeting decisions. The process of making effective corporate investment decisions and putting operating cash flows to good use should reflect the family business’s strategy and current situation. As a family business director, it is critical to evaluate which segment(s) are most attractive for current investment given the existing goals and strategies of the family business while maintaining awareness of market opportunities and limitations.

…determining how much debt is appropriate for your family business. Family businesses are financed with a combination of family equity and debt capital. Debt capital is attractive because lenders are generally content with a lower rate of return than equity holders. As a result, the prudent use of debt can reduce the overall weighted average cost of capital for your family business (and increase returns on the family’s equity capital). But, the benefits of debt are not free: adding debt to the company’s capital structure increases the risk faced by the family shareholders. Family business directors should carefully consider how much debt is appropriate based on the company’s asset base, earnings stability, economic and industry outlook, available borrowing terms, and family shareholder risk tolerances.

Final Thoughts

With spring rapidly approaching, we encourage you, as family business directors, to consider the uses above and to take a pulse on the value of your family business. Whether providing valuation calculations to estimate the value of your family business or serving as a neutral, independent sounding board in your deliberations, our family business professionals look forward to helping you develop appropriate answers to these questions for your family business. Give us a call today to discuss your needs in confidence.