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India is ranked third in terms of the number of family-owned businesses in the country. Identifying and streamlining the valuations in this sector is increasingly becoming important, considering the fact that family businesses contribute more than 70% of India’s GDP. But the big question is – “Do family businesses really know what they are worth?”

In many countries, legislations require public companies to report their financials on a quarterly basis. This is not often the case with family businesses, either because they are privately owned, or organized as partnership firms. Family businesses may go years without publishing proper financial statements, and knowing their true worth. This is one of the most challenging aspects in a family business valuation exercise.

While there are many business valuation articles on the internet that discuss this in general, in this article we aim to bring out the methodologies and challenges in valuing family businesses.

Challenges in Family Businesses

Many family-owned businesses face a plethora of challenges – difference in attitudes, aspirations and priorities of the family members. For the senior members of the family, it becomes an enormous challenge to keep the business and family intact. Some sacrifices are made here and there keep the balance and the momentum going. However, one of the most ignored areas is the valuation of the family business. How much the business is worth?

Getting formal family business valuation done by third-parties is quite uncommon. However, there are some situations that warrant a proper family business valuation report:

• Estate transfer
• For potential buyers
• Buy sell agreements
• Marital disputes
• Success planning
• Disinvestments or hive-offs
• Seek outside investments

The challenges to the business leaders is that most valuations take a historical approach to valuation. They require a formal structure to be in place for a number of years, with proper financial discipline. Most family business fail to meet these requirements, and face a challenge when posed with a family business valuation exercise.

Commonly Used Methods in Family Business Valuation

We look at the commonly used methods in family business valuation that a valuation analyst usually adopts:

Capitalization of Future Earnings Method¹

Most family businesses have a history of existence and stable earnings. This presents the right business case for using the capitalization of future earnings method.

This method uses the future estimated benefits to value the family business – usually earnings or future cash flows. Then use a capitalization rate to translate these future cash flows or earnings into a business value. This method assumes both tangible and intangible assets to be indistinguishable parts of the business. In other words, the critical component to the value of the business is its ability to generate future earnings/cash flows.

The biggest challenge of using this method is arriving at the capitalization rate, which could be a source of disagreement and friction amongst the family members. One of the biggest draw-backs of this method is that it ignores the assets on the balance sheet such as land, buildings, intellectual property and so on.

Discounted Cash Flow Method²

A discounted cash flow method if often considered in the valuation process, and uses future cash flows to arrive at the value of the business. A discounted cash flow analysis involves forecasting the appropriate cash flow stream over an appropriate period and then discounting it back to a present value at an appropriate discount rate. This discount rate considers the time value of money, inflation, and the risk inherent in ownership of the asset or security interest being valued.

In order to conduct a DCF analysis, you must project the financials for the future – usually 5-7 years; Then use an appropriate discount rate to discount these future cash flows to arrive at the family business valuation number. You need to have sustainable and predictable cash flows in order to use this method reliably.

Adjusted Net Assets Method

If your family business has large investments in assets such as real estate, farm land and so on, you can use the net assets method. The adjusted net asset method is a business valuation technique that changes the stated values of a company’s assets and liabilities to reflect its estimated current fair market values better.

A valuation expert can help you decide the best method for arriving the value for your family business. There is no ‘one size fits all’ solution to address the valuation game.

Issues in Family Business Valuation

There are two major issues in valuing family businesses:

• Management issues: Lack of a formal governance mechanism, lack of succession planning, reliance on key personnel are common management issues that could negatively impact the business value.
• Process Issues: Issues such as lack of financial discipline, lack of proper financial reporting, documented processes are all contributors to negatively influencing the value

In my experience, these pitfalls typically fall into two categories: management issues and operational issues. 

On the management side, I have seen businesses suffer in valuation due to a lack of a formal board; lack of succession planning for directors, which leaves the business vulnerable to loss of key personnel; improper employment of family members in senior positions; and inadequate family governance structures (such as a family council and family constitution.) 

On the operational side, a lack of business strategy; a lack of documented systems and procedures; and a lack of robust financial reporting can all damage a valuation exercise.

Developing a valuation method for your business is more than just good business sense; it can be extremely helpful when dealing with bankers, external stakeholders and the open market in general.  Being able to immediately determine the health of a business, its future direction, and the importance of that strategy can help communicate that value to outsiders who are not familiar with family businesses. 

The business valuation importance is often ignored in many family businesses. A valuation methodology can also help family business leaders understand the key drivers of business value. While conducting a full scale valuation exercise can be helpful, it doesn’t need to happen very often, as long as business leaders know how to quickly estimate value and assess whether improvements to their key drivers has been achieved.

Even if it the next generation that will be taking over the realms of your business, consider using buy-sell agreements as a guide to help them navigate the challenges of inheriting your business. This will be really helpful in unforeseen situations like death, mental incapacitation or if one of the partners decide to leave the business. Having proper legal documentation and a professional business valuation will help the business if such an event happens.

In conclusion, remember that a business valuation professional can help act as a business advisory during the valuation process. By identifying the key value drivers, entrepreneurs can make effective succession planning decisions to keep the business unhindered and running through the future generations.