Key Takeaways
Business valuation is based on expected future cash flows, growth opportunities, and risk rather than historical financial performance alone.
The same business can have multiple reasonable values because different valuation assignments serve different purposes and apply different standards.
Directors should focus on understanding the purpose, assumptions, and judgment underlying a valuation before comparing conclusions or making decisions.
Throughout this summer series, we have examined how family businesses allocate capital, fund growth, distribute cash, and provide liquidity to shareholders. Those decisions eventually lead to another question: What is the family business worth?
The question sounds straightforward, yet discussions about value often produce more confusion than clarity. A shareholder updating an estate plan may receive one valuation conclusion. The board may use a different value when considering a shareholder redemption. A potential buyer may offer a third number. Even two qualified appraisers can reach different conclusions.
Those values may all be reasonable because they are answering different questions.
Value Depends on the Future
A company's financial statements tell us what has already happened, while valuation is primarily concerned with what happens next.
At its core, the value of a business reflects the cash flow investors expect the business to generate, the growth prospects associated with those cash flows, and the risk that actual results will fall short of expectations. Historical results provide an important starting point, but investors do not pay for last year's earnings.
Consider two companies with the same earnings today. One has recurring revenue, a diverse customer base, as well as an experienced and stable management team. The other depends heavily on one customer and one key executive. Investors will not assign the same value to the earnings of those two companies because the outlook and risk associated with those earnings are different.
Growth also requires context. Revenue growth that consumes substantial capital or produces inadequate returns may contribute less value than shareholders expect. More measured growth accompanied by strong margins and disciplined capital investment may contribute more. The relevant question is how much cash flow the company can generate for investors after funding the needs of the business.
The Purpose of the Valuation Matters
Before debating a valuation conclusion, directors should understand the question the valuation is intended to answer. If cash flow, risk, and growth explain how value is estimated, the purpose of the valuation explains why different conclusions may exist.
The objective of an estate planning valuation is to determine the fair market value of an illiquid minority ownership interest for tax purposes. A valuation pursuant to a buy-sell agreement must follow the language contained in the agreement. An internal valuation used to evaluate a shareholder redemption program may focus on the value of the company to its existing owners.
A potential acquirer may view the company differently. A strategic buyer could expect to eliminate overlapping costs, expand into new markets, or generate additional revenue by combining the two businesses. Those buyer-specific benefits may support a transaction price above the company's value on a standalone basis.
The ownership interest being valued also matters. The value of an illiquid minority interest is less than the pro rata value of the entire company. The ability (or inability) to control business decisions and the lack of a ready market for private company shares will influence the value of a particular interest.
The valuation date matters, too. Company performance, interest rates, industry conditions, and investor expectations change. A valuation that was reasonable two years ago may no longer be useful today.
Valuation Requires Judgment
Valuation relies on objective evidence, including financial statements, industry data, public company information, and private transaction activity. Applying that evidence requires judgment.
An appraiser must determine whether historical earnings are representative of expected performance, assess the reasonableness of management's forecast, and evaluate risks such as customer concentration, management depth, competitive conditions, and capital requirements.
Reasonable differences in valuation conclusions usually originate in those assumptions and judgments rather than the arithmetic. When conclusions differ, directors should identify the assumptions, definitions, or facts that changed before deciding that one valuation is wrong.
So, What Should Directors Do?
Start by defining the question.
What decision is this valuation intended to support?
Estate planning, a buy-sell agreement, shareholder liquidity, strategic planning, or a potential sale may require different analyses.
What exactly is being valued, and as of when?
The assignment may concern the entire company or a specific ownership interest with particular rights and restrictions. It should also identify a clear valuation date.
What assumptions are being made?
Directors should understand the expectations for cash flow, growth, capital investment, and risk.
How will we explain the conclusions to shareholders?
A clear explanation of the purpose, assumptions, and process is more useful than presenting shareholders with a number alone.
Conclusion
Directors do not need to become valuation experts, but they do need to understand what drives value and how operational decisions impact that value. Shareholders may never agree instinctively on what the family business is worth, but they can agree on a credible process for answering a clearly defined question. In each case, clarity about the purpose of the valuation can prevent an understandable difference in perspective from becoming an unnecessary shareholder dispute.