Below in my latest published article for the Bauer Media Group, I show the importance of using accurate business valuations to help ensure the business can accurately communicate within itself and to external parties such as banks, look at  parts make it successful, its key advantages are and its overall true value. David Harland– Family Business Advisor

While public companies are required to report their financials on a quarterly and annual basis, family businesses may go years without knowing how much their business is really worth. Private companies don’t need to know the precise value of their business each day but they need to have a method for calculating that value to manage the performance of the business, plan succession, communicate with outside stakeholders, and help directors answer the critical question: Are we creating value today or destroying value?

A formal business valuation is rare, but there are many reasons why a family business might need to conduct a valuation exercise, such as: to develop a buy-sell agreement, during divorce proceedings, to plan succession, to sell the business, or to seek outside investors.

The challenge to business leaders in these circumstances is that business valuations often look backwards and require that certain organizational structures be in place for a number of years. Family businesses that have not taken steps to protect the value of their business may find themselves in trouble should a formal valuation need to take place at short notice. In order to understand what business leaders can do to protect (and increase) the value of their company, we need to understand some of the commonly accepted methods of valuating a family business.

There are many valuation methodologies, however, there are a few methods that are commonly used for family businesses. A valuation expert can help you determine which method is right for your business and circumstances. It’s important to keep in mind that each option has limitations, and may focus on one area of the business at the cost of ignoring another.

Capitalisation of future maintainable earnings is a method used most often for mature businesses with a history of stable earnings. It focuses on valuing the business at some multiple of its maintainable earnings, with the multiple determined by factors like earnings stability, risk rating, and industry growth. It can be difficult for family businesses to determine a reasonable multiple, which can be a source of friction between stakeholders.

The discounted cash flow method uses the free cash flow of the business to calculate value based on the sum of the forward cash flow discounted to its net present value. This approach is best for businesses with predictable cash flows and a defined time life.  One of the clear drawbacks of this method for some businesses is that it can be difficult to develop long-term budgets and extrapolate cash flow requirements into the future, requiring a number of assumptions that may be difficult to support with evidence.

A valuation based on net realizable assets focuses only on the tangible asset value of the business. This formula is particularly useful for transportation, farming, or engineering businesses with significant investments in plants and equipment, but ignores intangibles like goodwill.

There are a few things that can damage the value of a family business, both in terms of business health and during the valuation process (those who read my column regularly will be familiar with these as I bring them up frequently.) 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 and external stakeholders. 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. 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.

For more on family business or for an expert valuation contact FINH on 07 3229 7333