As a fellow business owner, I know first-hand how critical it is to understand the fair market value of your company. This is especially true for those of us running family enterprises. Accurately valuing our businesses serves so many important purposes – selling the company, securing financing, estate planning, resolving shareholder disputes, calculating damages in lawsuits, and more.

Unfortunately, appraising a family business can be tricky. The complex dynamics between family and business make these valuations uniquely challenging. As owners, we need to take steps to get fair assessments. And appraisers have to master techniques to handle family business nuances.

In this post, I’ll share my insights from 20+ years advising family companies. You’ll learn common pitfalls in family business valuations and how to avoid them. I’ll overview standard appraisal approaches and adjustments made for family entities. And I’ll suggest best practices to ensure your company gets an equitable valuation.

While each family business is unique, the valuation fundamentals remain the same. So let’s dive in!

Understanding Business Valuation

Before delving into the intricacies of family business appraisals, it is helpful to understand some basics about business valuation in general. There are three main approaches used:

Asset-Based Approach – Totals the fair market value of all business assets less liabilities. The value of assets like property, inventory, and equipment are added together. This approach may undervalue a profitable business.

Market Approach – Estimates value by comparing the subject company to similar businesses recently sold or public companies trading on stock exchanges. Adjustments are made for differences between the comparables and the subject company.

Income Approach – Projects future cash flows and applies a capitalization rate or discount rate to determine present value. Value is tied to the capacity of the business to generate continuing income.

Appraisers may use one or more of these methods and weight them to derive a final opinion of value. The approach depends on factors like the industry, profitability, intangible assets, and appraisal purpose.

Challenges in Valuing Family Businesses 

While business valuation is part science and part art for any company, appraising a family enterprise presents some unique challenges for owners and appraisers.

#Lack of Market Comparables

Finding relevant market comparables is key to the market approach, but can be difficult for a family business. Many are privately-held companies without publicly-traded peers for benchmarking. Even within the same industry, family companies vary widely in size, structure, management, and financial metrics.

#Intermingled Personal and Business Finances 

Family business finances are often intertwined with personal finances of the owning family. This commingling can take many forms – shared facilities, transfer of assets without payment, personal expenses paid by the business, undocumented shareholder loans, and uncompensated family member labor. Entanglements make it harder to get a clear picture of cash flows tied strictly to business operations.

#Role of Family Dynamics and Relationships

Family ties intrinsically affect business decisions and financial management. Nepotism in hiring, non-arm’s length transactions, resistance to change, and discounting services or products for relatives are some examples. Appraisers may lack insight into family dynamics that cause financial outcomes different than a non-family-owned peer.

#Succession Planning Concerns

Leadership transitions from one generation to the next is a major event for a family enterprise. Uncertainty around succession plans – or lack of documented plans – can significantly impact business valuation. Appraisers may apply discounts if future ownership control or income capacity is unclear.

#Identifying Intangible Assets

Family businesses often have intangible assets not reflected on the balance sheet, like customer relationships, trademarks, patents, brand equity, and industry reputation. These can enhance value significantly but be difficult to quantify. Appraisers must exercise judgment around the contributory value of these invisible assets. 

Approaches to Valuing a Family Business

Despite the challenges outlined above, appraisers have techniques to value family enterprises reasonably and objectively. Let’s examine how each of the three standard approaches are applied to a family-owned company.

#Asset-Based Approach

– Begin with a professional third-party valuation of fixed assets like real estate, production equipment, vehicles, etc. Adjust book value to fair market value.

– Add balance sheet accounts like cash, accounts receivable, inventory using adjusted book values or actual market values.

– Assess the fair market value of intangible assets not captured on balance sheet, such as trademarks, patents, and brand equity. The discounted cash flow method is often used.

– Subtract all liabilities like accounts payable, debt, and other obligations

– For controlling interests, apply a control premium, typically 30%+

– Apply marketability discounts for lack of control, lack of marketability of shares, rights restrictions, etc. Discounts may range from 10% to 40%.

This approach will yield a baseline of the equity value of the family business based on the adjusted net asset value. Adjustments to the book value and identifying off-balance-sheet intangibles are key to avoiding an undervaluation.

#Market Approach 

– Identify public companies or industry transactions involving non-family-owned peers to use as benchmarks

– Compare revenue, profit margins, growth rates, cash flow, and other metrics to derive valuation multiples like P/E, EV/EBITDA, etc. 

– Adjust multiples based on factors like size, risk, management, competitive position, brand strength, and growth outlook

– Apply adjusted multiples to the subject company’s metrics to estimate value

– Make additional adjustments for family-specific factors not reflected in multiples, like planned succession, share transfer restrictions, or compensation norms

Selecting relevant comparable companies is the most important step for a credible market approach valuation. The appraiser must fully understand the family business and its competitive landscape to choose appropriate peers and metrics comparisons.

#Income Approach

– Project future cash flows for at least 5 years based on historical financials, growth trends, and management expectations

– Calculate terminal value at end of projection period using a terminal growth rate or exit multiple

– Discount projected cash flows to present value using the company’s weighted average cost of capital as the discount rate

– Apply adjustments to discount rate or cash flows for family-specific risks not captured in WACC 

– Value intangible assets separately using multi-period excess earnings method

– Add excess non-operating assets like real estate, investments or cash reserves

The income approach allows an appraiser to fully reflect the earning capacity of a family business. Careful cash flow projections are necessary to capture advantages like low family member compensation as well as risks like unplanned succession.

Best Practices for Fair Valuation

Family business owners can take proactive steps to minimize appraisal challenges and help ensure they receive a fair, supportable valuation:

#Using Professional Appraisers 

Work with reputable, experienced appraisers holding credentials like the Accredited in Business Valuation (ABV), Certified Business Appraiser (CBA), or Accredited Senior Appraiser (ASA). Their objectivity and expertise are invaluable.

#Transparency About Finances and Operations

Openly share accurate financial statements, tax returns, legal documents, and details of related party transactions with appraisers. Explain unique aspects of family member roles, compensation, or other insider relationships impacting the numbers.

#Establishing Policies and Procedures

Implement clear rules for financial management, asset transfers, dividends and distributions, shareholder rights, and operational practices. Document business governance and family employment policies. This provides the structure appraisers need for benchmarks.

#Planning Ahead for Liquidity Events

Appraisals for events like selling the company, shareholder buyouts, or succession should be done well in advance. This avoids “fire drills” with suboptimal timing and allows implementing changes to enhance value.

#Setting Appropriate Compensation for Family Members 

Family member salaries and benefits should be consistent with market rates for their role and experience level. Below-market compensation will distort financials used in a valuation.

#Managing Family Member Expectations

Address family expectations around valuation outcomes early and often. Share appraisal methodologies and typical valuation ranges. Explain that appraisers must remain objective – a “high” valuation may have unintended tax or transfer consequences.

Certifications and Credentials for Business Appraisers

There are many professional certifications for business valuation analysts. Here are some of the most common and respected:

– Accredited in Business Valuation (ABV) – Specialized designation offered by the American Institute of CPAs. Requires being a CPA plus examination, experience, and continuing education requirements.

– Certified Business Appraiser (CBA) – Credential from the Institute of Business Appraisers. Applicants must meet education, experience, and exam qualifications. Recertification every 5 years is mandatory.  

– Accredited Senior Appraiser (ASA) – Designation in business valuation from the American Society of Appraisers. Candidates must be state-licensed or certificated appraisers and meet rigorous education, experience, and ethical standards. The ASA is considered the “gold standard” in appraisal credentials.

– Certified Valuation Analyst (CVA) – Qualification offered by the National Association of Certified Valuation Analysts. Requires a bachelor’s degree, training, two years full-time experience, and passing exams. Continuing education is compulsory. 

Ideally, a business appraiser should have an accounting, finance, or business background plus a professional valuation certification from a recognized organization. Credentials signal competence, expertise, and adherence to ethical valuation standards.

Conclusion

Appraising family businesses presents some unique challenges due to the intertwining of family and business finances, dynamics, interests, and plans. However, professional appraisers have the tools and experience necessary to value these entities reasonably and objectively. 

Owners should seek qualified, reputable appraisers. They should also proactively address areas like financial transparency, policy documentation, compensation norms, and succession planning that can impact their company’s valuation. With proper preparation and expert valuation, family enterprises can be appraised equitably based on their true fair market value.