Working together can bring out the best — and worst — in families. Here are some issues business valuation experts consider when appraising these entities.

Family members on the payroll

Family-owned businesses aren’t usually run like large public companies. For starters, “family business” and “nepotism” often go hand in hand. Some business owners hire family members because they’re perceived as more trustworthy, while many hire them out of obligation or to satisfy a desire to pass the business on to their offspring.

When valuing family-owned entities, valuators must objectively consider whether family members are qualified for their positions and whether their compensation is reasonable. In some cases, management of a hypothetical buyer might want to consolidate family members’ positions and use fewer people to perform their duties. As a result, valuators often make an upward adjustment to cash flow to reflect the excess expense of employing relatives.

But the reverse may also be true. Some family businesses overwork or underpay related parties. Consider, for example, business owners whose passion for their work and desire to succeed lead them to work exceptionally long hours.

When evaluating a related party’s compensation, valuators look beyond the family member’s base pay. For example, they must also adjust for payroll taxes, benefits and perks. Extraneous perks may include such things as allowances for luxury vehicles or country club memberships.

Related-party transactions

Family-owned businesses may engage in other transactions with family members, such as rental contracts, supply agreements and related-party loans. Experienced valuation experts know to inquire whether these transactions exist and are at arm’s length.

Often, related-party transactions are sweetheart deals that require adjustments to the company’s income stream for valuation purposes. For example, suppose a retailer rents space from a relative at a discount from what she would charge an unrelated business. If the retailer needed to be valued for, say, the owner’s divorce, the valuator would consider reducing its cash flow to the extent that the related rental rates are below market rates.

Management style

Family business owners tend to have a more personal management style that favors gut instinct and trust over formal written policies. Many family business owners also favor fiscally conservative business strategies and non-financial goals, which often lead to slower growth and lower profits. Particularly when valuing controlling interests, experts consider how much a family-owned business would be worth in the hands of an unrelated hypothetical buyer.

In addition, the casual management style that characterizes many family businesses can lead to weak internal control systems — and even fraud. Valuation professionals take this additional risk factor into account and watch for the warning signs of fraudulent activity.

Key person discounts

Although family businesses often rely heavily on one individual, key person discounts aren’t appropriate for every family-owned entity. These discounts are relatively rare and reserved only for those businesses that would suffer a significant monetary loss if the key person left the company.

The typical approach to quantifying a key person discount involves estimating the company’s monetary loss if the key person were to depart. Another approach is to estimate a percentage discount after considering several factors, such as the key person’s skills, the company’s financial position, employee turnover and management structure.

Owners can take preventive measures to safeguard their companies, such as requiring key managers to sign employment or non-compete contracts. Family business owners may also consider implementing a viable succession plan or taking out a life insurance policy on the key person’s life, with the company as the beneficiary. Such risk minimization techniques generally offset any key person discount.

It’s all relative

In most cases, family-owned businesses should be valued based on how much they would be worth to third-party buyers and sellers in arm’s length transactions. So it’s important to hire an experienced valuation professional who recognizes common issues these entities face.

(This is Blog Post #1572)