NOTIONAL VALUE, MARKET PRICE & THE SUCCESSION PLANNING PROCESS
In the June, 1997 issue, Milne and Cowan examined the importance of the family business history within the context of the succession planning process. It was argued that, when used as a diagnostic tool, a family business history could help to preserve and promote those aspects of a company’s culture and value systems that have been integral to its success. In this article we shall examine the importance which an understanding of valuation-related issues plays in the succession planning process. The underlying premise is that a greater awareness of valuation theory and application will provide a framework for decision-making that will promote value preservation and enhancement within the succession planning process.
In the first section, we will investigate the issue of value in both a notional and an arm’s length setting. In doing so, we will examine some of the more common methodologies used when valuing a business and identify some of the factors which one must consider in understanding the important differences between a business’ notional value and its value in an open market setting. We will then proceed to demonstrate how the difference between notional value and market price can be reconciled among the parties to a succession plan.
Value, Price & the Succession Dilemma
The overriding question faced by family businesses generally is whether to transfer ownership of the business to the next generation or to sell the business to an arm’s length party. Each alternative has its own set of problems. In most instances either path is a course in uncharted waters. Resolving this dilemma requires confronting difficult interpersonal and financial questions that will have an impact on present and future family relationships. It is a challenge best dealt with in a systematic fashion which all stakeholders can understand.
Throughout the succession planning process, and indeed, throughout the life of a business, the issue of a business’ value will frequently arise. The perception of value will vary for each individual and will be shaped by many factors, including the role that the business has played or is expected to play in his or her life. Value will drive many of the decisions made in the succession process. This is easy to appreciate when one considers the differing economic goals and motivations of the following parties:
- Retiring owner/manager
- desire for financial liquidity
- worry-free retirement
- Active successor(s):
- continuity of the business
- preservation of financial strength of the business
- operational and management control
- Non-active successor(s):
- return on investment
- preservation/enhancement of value of shareholding
- liquidity of investment
- appropriate influence over the business
Reconciling these differing perspectives is a significant challenge within our rapidly changing economic, business and personal environments. A succession plan is a dynamic process which must be designed to accommodate all aspects of change, including the changing value of a business. Once an initial succession plan is put in place, the relationship between the value of the business to the family and the value of the business to an outside third party will fluctuate, sometimes greatly. Consequently, shareholders must be familiar with both notional and market- based concepts of value as they relate to the business.
The dynamics of value and the impact of changing perceptions of value is well illustrated by a recent situation involving a family-owned business operated by a father and son. The company was well established and profitable and was owned in its entirety by the father. For a ten-year period, the son had played an increasingly important role in the success of the business. When the father took an extended leave for health-related reasons, the son stepped in and helped to run the business.When the father returned he had the business valued and offered to sell his interest to the son on the basis of the valuation. Their positions became virtually intractable due to differing perceptions of value. The son insisted that the value of the business was largely due to his own efforts. As such, he had no intention of paying for value he believed he had helped to create. The father, who required his equity for retirement, took the view that the son had not accrued any ownership of the business, by virtue of the substantial amounts he had been earning as an employee.
Clearly, this unfortunate situation points to the important role which understanding and communicating on valuation issues plays in establishing agreement on value and its realization in the succession planning process. In the above example, had the son known that he was expected to purchase his interest in the business on an arms’ length basis, he may well have been prepared to accept a reduced salary and build his equity by contributing the balance. Given the passage of time, it became difficult for either party to accept the other’s position. The father’s health was failing and he required his equity on a fairly immediate basis. The son had only a limited amount of capital available and faced a difficult challenge in raising funds externally. The passage of time significantly limited the alternatives available to them and created a level of acrimony that imperiled the future of the business and their own personal relationship.
Questions of value arise under many scenarios where it is necessary to ascertain the value of the business in the absence of an arm’s length, negotiated sale. Typically such valuations are referred to as notional market valuations and are undertaken pursuant to, among other things, income tax reorganizations, matters of family law, valuation provisions of shareholder agreements and the various remedies available to shareholders under provincial corporations statutes. Within the notional market context the most commonly encountered value term is ‘fair market value’. Other notional value terms such as ‘fair value’ or simply ‘value’ generally derive from fair market value. For purposes of this article fair market value shall be used at all times. The widely accepted definition of fair market value is:
The highest price available in an open and unrestricted market between informed and prudent parties, acting at arm’s length and under no compulsion to act, expressed in terms of money or money’s worth.
Key Valuation Concepts
Pricing a business for purposes of an open market transaction and valuing a business for notional transaction purposes are both based upon four fundamental concepts:
- Price/value relates to a specific time
Any valuation relates to a specific time only. We are able to use only the information and the environment that we are aware of today in arriving at value. Influencing factors may change materially, even over a relatively short period of time. For this reason it is imperative that the business owner and his or her advisers have a sound understanding of the concepts of value and the factors that affect it on an ongoing basis.
- Price/value is a function of future expectations
Prospective purchasers of a business, strategic or otherwise, are primarily interested in what the future holds for the business. While historic results are a guide to both the business valuator and the prospective purchaser, it is the future going-concern results that will be used in the determination of value.
- Price/value is a function of free cash flows
The value of a business is a function of what a purchaser would expect a business to generate in terms of discretionary after-tax earnings or cash flows.
- Price/value is directly correlated to the market demand for a business
The number of legitimate buyers that exist in the marketplace at a given point in time will have a direct impact on the price realized by the vendor. The liquidity of a business, as determined by the market demand for that business, is an important factor in establishing the vendor’s negotiating position. Typically, a greater number of buyers increases the opportunity for the vendor to maximize the price received.