Key Takeaways
Family business directors should remain involved in the valuation process beyond signing the engagement letter. Understanding the report’s assumptions and conclusions provides a common foundation for shareholder discussions and informed decisions.
Directors should review the valuation’s purpose, methods, financial projections, and market evidence. They should also understand how changes in company performance, expectations, and market conditions affect value from year to year.
Annual valuations and consistent communication about the factors affecting value can help reduce shareholder surprises and conflict.
Family business directors are often asked to make decisions that depend on what the company is worth. Whether considering a shareholder redemption, reviewing a buy-sell agreement, or evaluating an ownership transfer, directors need a reasonable basis for determining the value of the family's investment.
A consistent and reliable valuation process provides a good starting point. Directors’ involvement should continue after signing the annual engagement letter. Reviewing the report, discussing assumptions with the appraiser, and understanding changes from the prior year help directors make informed decisions and explain the valuation to shareholders. That responsibility is particularly important when shareholders have competing interests or different expectations about value.
A Common Starting Point for Shareholder Discussions
Valuation requires judgment, and different assumptions about future performance, risk, and market conditions can produce different conclusions. A valuation supported by appropriate methods, reasonable assumptions, and relevant financial and market information provides a common foundation for shareholder discussions about strategy, risk, and expected returns. Family business directors who take the time to understand the valuation analysis will be better prepared to address questions about both the valuation and broader topics of shareholder concern.
Questions Directors Should Ask
When reviewing a valuation, directors should look beyond the final number and consider the assumptions and analysis used to arrive at the conclusion. Several questions can guide that review:
Is the purpose of the valuation clear? The appropriate standard and level of value can depend on whether the valuation is being prepared for a shareholder redemption, estate planning, a buy-sell agreement, or another purpose. Directors should understand what is being valued and the assumptions underlying the engagement.
What valuation methods were used, and why? Directors should understand the approaches considered, why particular methods were selected, and how the appraiser weighed the resulting indications of value. Changes in methods or their relative emphasis should be explained.
Are the financial projections reasonable? If the valuation relies on projected earnings and cash flow, directors should evaluate whether those projections are consistent with the company's historical performance, operating plans, and expected capital requirements.
Are the company's risks appropriately reflected? Customer concentration, management succession, financial leverage, and competitive pressures can influence value. The valuation considers the risks that are relevant to the company's future cash flows.
Is the market evidence relevant? Valuation multiples observed in public companies or transactions can provide useful benchmarks, but directors should understand how differences in size, growth, profitability, and risk affect comparability.
Can changes in value be explained? When valuations are prepared regularly, directors should understand how changes in financial performance, expectations, capital structure, and market conditions contributed to the latest conclusion.
Directors do not need to become valuation experts to ask these questions. However, they should understand the key assumptions and annual changes before relying on the report or communicating the conclusion to family shareholders.
An annual discussion with the appraiser gives directors an opportunity to work through these questions. Comparing the current and prior reports can also help identify assumptions that need further explanation, including those carried forward from the previous year.
Communicate First
A valuation is more difficult to explain when shareholders encounter it during a contentious transaction. If the family has not discussed value in several years, differences between shareholder expectations and the current valuation conclusion can become a source of conflict.
Regular valuations, a clearly defined valuation process, and communication about the factors affecting value can help reduce these surprises. Directors should also consider whether the company's buy-sell agreement provides sufficient guidance regarding the valuation process before a triggering event occurs.
The annual valuation review helps directors prepare for those conversations. When shareholders ask why the value has changed, directors should be able to explain the principal reasons and how they relate to the company’s performance and prospects. That understanding makes the valuation a more useful basis for decisions affecting the family’s investment.