Being an optimist, I always look for the silver lining. Maybe that’s why I believe this is a great time to transfer interests in family held businesses. By acting now, you ensure a bargain rate that can mitigate pending estate and income tax problems for the senior generations.
Businesses, like real estate, are valued using three methodologies: the market approach, the income approach and the underlying asset or cost approach. Any way you slice it, all three methods currently result in dramatically reduced values when compared with pre-2008 numbers.
The market approach
The market approach requires researching “comps” in the marketplace by considering both the guideline company method (publicly traded companies resulting in a marketable minority value) and the transaction method (sales of typically smaller businesses valued as a controlling interest).
The guideline company method attempts to develop a correlation between a closely held family business and its publicly traded counterpart. The problem is, most publicly traded companies are too large to be considered truly comparable because of diversification of product mix, layers and sophistication of management, deeper capital resources and other factors. That’s why this method is rarely used in valuing private sector companies, particularly in these volatile times.
The transaction method relies on transactional databases for statistical data by industry regarding sales price, terms and pricing multiples in relation to revenues, earnings, book value and so forth. Prior to January 2008, I used this method as one of my primary valuation metrics. However, when considering the use of transactional databases as a primary valuation methodology in today’s marketplace, it’s nearly impossible to find reliable data points for business sales post-2008. The market has virtually dried up: How do you rely on pre-2008 transactional data when the world is a different place today?
The income approach
The income approach is based on the theory that the value of any asset is based on the present value of its expected future returns. When using the income approach, one must first develop a cash flow model by either using historical data to estimate what will take place in the future, or developing a reliable forecast model based upon anticipated future results.
Where are the holes when considering either of these two methods? Let’s say that, prior to 2008, your business had a predictable and constant profit stream that would indicate the use of a single period cash flow model. Is that historical performance a good indicator of what will happen going forward, given the current recession? How about developing a reliable forecast model to implement a discounted cash flow method? To start, no one has a crystal ball that will pinpoint turnaround probabilities and a return to profitability, particularly for small businesses. The valuation conclusion when considering a single period capitalization model or a discounted cash flow approach is speculative at best.
To further complicate the use of the income approach, how do you develop a supportable discount rate or cost of capital to apply to the cash flow stream in this environment? The cost of capital compensates an investor for the passage of time, the expected rate of inflation and the additional risk premium associated with investing in a business opportunity (as opposed to a less risky or possibly risk-free scenario).
The asset approach
Since the first two methods described are problematic at best, we’re left with the asset approach. A significant number of businesses that might previously have been valued using the market approach, the income approach or a combination of the two must now live with the fact that their current value is the fair market value of existing assets minus liabilities.
The silver lining? This is a phenomenal time to consider shifting ownership of family businesses to the next generation! Since business values may be at all-time lows, it’s a perfect opportunity to transfer illiquid business interests to family members by using creative gifting or sales techniques.
Jim Andersen, founding partner of Andersen & Company, is now a partner in the consulting, business valuation and litigation practice area of Burr Pilger Mayer in Santa Rosa. For more than 20 years, Jim has been taking North Bay businesses through the business valuation and succession planning process. You can reach him at (707) 524-6530 or at jandersen@bpmllp.com.
