Family business leaders need a way to take the pulse of their business on a regular basis.
Publicly traded companies are required to constantly report their financials and while it requires effort and transparency, it also means they have an ongoing idea of the business’ value.
Private firms don’t have these metrics to guide their decision-making and so often have a loose grip on what their business is worth -- which can be a bad thing for ongoing strategy.
While business leaders do not need to know the precise value of their firm on a daily basis, they need to be able to quickly articulate the strategy, key value metrics and profit centres of their company. Valuation is a tool that helps business owners focus on the question: are we creating value or destroying value today?
Using informal valuation in strategy
Formal business valuations customarily only happen during milestone events like succession, capitalisation, or the sale of a business. In these cases, the valuation serves to identify and explain the key drivers of your business and arrive at an objective financial value.
However, regularly working through an informal valuation exercise helps business leaders understand their competitive advantages and identify weaknesses that must be addressed. If you ever plan to sell or pass on your business, or seek outside investors, it’s critical that you take steps to understand exactly where the business’ value is coming from and how to protect it.
There are several approaches commonly used for closely held businesses; they all depend on a variety of assumptions but some methods are more reliable than others.
It can be tempting to take a market approach by valuing your business on the basis of the sale values of similar firms, but this method usually ends up being more of an overly confident stab in the dark.
Using cash flow to know
In my opinion, all valuation methods are a variation on the discounted cash flow method, which is the only approach that estimates the true value of your business.
Ultimately, all that matters to your stakeholders is how much cash is available once all the firm’s operating expenses have been satisfied and necessary investments in the business have been made.
One drawback to only using financials as a basis for business valuation is that these indicators are always lagging. Past performance cannot predict future value and it is important to accept that fact.
Another problem is that creative accounting can be used to arrive at a desired outcome, which completely defeats the purpose of a valuation -- so it requires owners to be completely honest with themselves.
The family connection
Valuing a family business is as much art as it is science. Undertaking a valuation requires more than just looking at the financials, estimating cash flow, and coming up with earnings multiples. It also requires understanding the beating heart of the business and its history.
Family businesses often struggle to explain the value of the family connection to outsiders, who don’t have the requisite experience. That disconnect is one of the reasons why family businesses have trouble acquiring capital from traditional lenders. To get around that, many firms turn to a global network of family business investors who understand how to value and nurture family business capital.
At its most basic level, a valuation exercise is attempting to quantify the following:
– What is the future earning potential of this business?
– What resources are required to produce that revenue?
– How do those estimates change under different assumptions?
– What are the durable competitive advantages of the firm and how much are they worth?
– What weaknesses exist that could threaten future profits?
If you answer those questions about your business, not only will you have a better idea of where you stand financially, but you’re much more capable of evaluating your firm’s strategic position and future direction. And valuation also helps you identify any weaknesses.
Issues like family friction, lack of succession planning, or the absence of formal governance structures will often harm business operations. In the same vein, lack of innovation, high employee turnover, and macro threats to the business all suggest increased business risk.
The bottom line is developing a valuation method for your business and understanding the key drivers of your future profitability are critical to successful strategic planning. Just knowing how to quickly arrive at a rough value will help you assess the health of your business.
David Harland is managing director of FINH and an FBA and FFI accredited Adviser.