Establishing the Right Price For Your Family Business

While the ownership interest in the family business is often the largest asset in the owner’s estate, it also can be the most difficult value to assess. The right price depends on the buyer and the purpose of the sale.

In addition to family members who are active in the business, inactive family members may also be prospective buyers. To family members, no matter how close or distant they may be, the business may not only represent an investment, but also a family legacy.

Potential buyers are not limited, however, to family members. Business owners in the same or similar fields may wish to acquire it to enhance their own business or just to eliminate the competition. In such cases, the business’s purchase price can often be higher than what a reasonable person who reviews the financial statements would be willing to pay.

Employee groups and management groups also constitute potential buyers. A family business owner can sell to an employee stock ownership plan (ESOP) and reap tremendous tax benefits, or to a management group in a leveraged or unleveraged buyout.

Another option is to go public. If the owner wants to stay involved in the business while adding to its value to achieve a higher price in the future, going public can be a viable option. This, too, will yield a different price, depending on the value of the company’s stock to investors.

Setting the Purchase Price
Establishing a price for a buyout is sometimes controlled by market conditions. For example, in today’s market, going public may provide a purchase price multiple that is greater than the amount ordinarily warranted, because of the public’s thirst for additional investments in a rising stock market.

Sometimes the purchase price is set according to the value of the business and the owner’s cash needs in retirement. It can also be controlled by a family business member’s ability to buy out the stock, which is why establishing a price for the business is important for estate and gift planning purposes.

Even if the business is not purchased outright, establishing a price for it is important for determining transfer tax cost, for which the Internal Revenue Service (IRS) has prescribed appraisal guidelines in Revenue Ruling 59-60. This ruling sets the standards for determining fair market value as opposed to strategic or liquidation value. The considerations in Rev. Rul. 59-60 have now been extended by many appraisers and the courts well beyond the estate and gift tax area.

Typically, valuations on closely held family businesses are subjective, often controlled by factors beyond the control of the family business owner. The value is often different for different purposes. When the price to be established is for a sale to an ESOP, the valuation will depend on a qualified appraiser’s opinion based on the company’s financial statements and certain other outside information. ESOP valuations tend to be conservative and generally follow the guidelines set forth in Rev. Rul. 59-60.

Appraisal Methods
While Rev. Rul. 59-60 does not prescribe actual methods of appraisal, several conventional methods have become generally accepted.

The Excess Earnings Method.
The first appraisal method is the excess earnings method. Under this method, the balance sheet is restated from cash to the accrual method, taking into account receivables and payables. The balance sheet is also restated to reflect the fair market value of assets rather than their cost. After restating the balance sheet, the adjusted book value is determined. Those earnings may be weighted or a simple average may be used.

A capitalization rate is then applied to those earnings. The capitalization rate depends on the industry and the rate of return that an investor wants. The goodwill amount is added to the adjusted book value to determine the company’s worth. The appraiser then will value the block of stock that is the subject of the valuation, possibly applying discounts or premiums, depending on whether the block is a majority or minority interest and how marketable it is.

The Capitalization of Earnings Method.
The capitalization of earnings method is a variation on the excess earnings method. This method puts more weight on the income statement than on the balance sheet and is often appropriate where the company’s earnings potential is of paramount importance. Under this method, the same analysis is made of the income statement. However, once the excess earnings are determined, a multiple that is generally higher is applied to the excess earnings of the company to determine its value. No value is placed on the assets of the company.

Adjusted Net Worth Method. Another variation is the adjusted net worth method. This is typically used in companies where the assets and liabilities on the balance sheet are the major part of the value and the earnings of the company are of much lesser importance. Thus, this method focuses on the balance sheet and entirely ignores the income statement. Under this method, the balance sheet is restated on the accrual method, changing assets to fair market value. The adjusted net worth of the company is determined and that is the amount used for valuing the company. Companies that have intrinsic value, such as real estate, will find this approach valuable. Where companies are in a start-up phase or where the company’s future business is somewhat different than its past business, a different method may be required.

The Discounted Future Earnings Method.
This method provides a good benchmark for what the company is worth. Earnings are forecasted into the future and the value of those earnings is discounted at the current interest rate. One problem with this method is that the projected future earnings may or may not come true. Because it’s an estimate, it is less exact than other valuation methods.

Comparable Sales. When there have been previous transactions in the stock of the company or similar companies, those comparable sales are a good indicator of the value of your company. Where transactions are in stock of the company being valued, unrelated parties may not establish a consistent price that reflects the fair market value price. Sometimes a minority owner seller is relatively uninformed and unsophisticated. Thus, this individual may settle for a price that is lower than the fair market value.

In other cases, the seller may know that the value of the stock is understated, but is willing, because of personal circumstances, to take a lesser price. On the flip side, it is sometimes true that an inside buyer is willing to pay more to a nonfamily minority owner to gain control of his or her stock. This sometimes sets an unrealistically high value for the company.

Thus, comparable sales may be instructive, but not always indicative of value. It is extremely difficult to find data on closely held companies and nearly impossible to find publicly traded companies that are similar to a closely held business. Thus, comparable sales of other companies are usually not instructive. While there are other methods that can be used to value a business, those discussed here are the most common. After the appraiser has used several methods to obtain a business valuation, he or she will choose the method that produces the most appropriate value for the current circumstances or, he or she will take an average of the values produced by those methods.

When the valuation is done for transfer tax purposes, a similar analysis of fair market value is conducted, but in this case the appraisers are more aggressive because there are fewer parties to object to the analysis.

In a transfer tax situation, the IRS and the transferor are adversarial parties and negotiations are merely for determining the amount of the transfer tax. The final value may not reflect the actual value that a willing buyer will pay and a willing seller will accept.

More difficult questions are asked when a sale is negotiated to company management or to another family business member. Many family business owners begin negotiations with an outside appraisal. In most cases, this is a mistake. When an appraisal is done prior to negotiations or an initial offering, the seller develops an expectation of the company’s value, which may be unrealistic.