Family-owned business valuation is more art than science.

The founding owners of a successful multi-location seafood restaurant chain turned their years of hard work into a nice nest egg by selling to a publicly held company. A win-win for both parties? Hardly. The restaurants were later sold back to the founders at pennies on the dollar. Smart people did the due diligence and believed a fair value was paid. So, what went wrong?

Many "private" businesses are family businesses, and some large publicly held businesses are family-controlled. In the tale above, the outcome might have been different if, when valuing the business the unique aspects of valuation of family businesses were considered.

Business valuation encompasses both science and art. Avoiding horror stories arising from overstated or unsustainable valuations requires lots of art, along with the science of valuation.

The "science" of valuation is grounded in academia and based on the application of three generally accepted valuation approaches: the income approach, the market approach and the cost approach. Each approach possesses specific characteristics which are more or less applicable for a given valuation scenario. The income and market approaches are typically relied upon for "going concern" business valuations; the cost approach generally applies to liquidation analyses.

The income approach discounts the free cash flows of the business to present value at a discount rate that reflects the total risk of the free cash flows to the investor, and normally assumes that the business will continue in perpetuity.

The market approach utilizes implied market multiples of financial statistics (revenue, free cash flow, total assets, etc.) observed in the public trading markets and publicly announced mergers and acquisitions. These implied market multiples are multiplied by the subject company's comparable financial statistics to provide indications of value. Such multiples, adjusted for "lack of marketability" and "controlling interest," can also be used to value family businesses.

The art of valuation is rooted in the experience of the valuation professional. Seasoned judgment must be applied to the various valuation approaches, the current M & A market, the investment perspective of the valuation (basis of interest as controlling vs. minority and marketable vs. non-marketable), and the company's value drivers (intangible assets, market positioning, barriers to entry, etc.).

Fair Value vs. Going Concern

In the family business arena, substantial "art" must be applied to valuing the intangible assets and assessing their sustainability or vulnerability to loss. Here, the focus is on the difference between the fair market value of the individual identifiable assets and liabilities of a business and its total "going concern" value based on one of the valuation methodologies.

This difference constitutes an intangible asset that can be thought of as arising from the special skill, experience, knowledge and dedication of the owner or key employees and/or the unique product or service competitive advantages of the business. The simple subtraction ("going concern" value--fair market value of individual assets and liabilities = intangible value) places a dollar value on the intangible intellectual capital of the business. It is also how buyers and sellers can agree on a price that exceeds the fair market value of the underlying assets and liabilities.

Routine accounting does not recognize this intangible value. But in family businesses, the factors that give rise to this value are so crucial to success and so susceptible to loss that they require special analysis. Thus, for purposes of valuing a family business, this intangible value must be disaggregated and analyzed.

Family business owners are acutely aware of business success factors. They should be encouraged to think through categories such as key customer and vendor relationships, image and brands, management culture and processes, key employees, human resource systems and trade secrets, then to assign value to each critical success item such that the total intangible asset has been accounted for.

Then, each intangible value item must be evaluated by assessing whether there is exposure to loss resulting from the death or termination of employment of the owner or key employees, or from other unique profit drivers. If exposure exists, the valuation professional must assess (as a percentage) the capacity of a person or entity to take the item and the likelihood that the adverse event would occur. The combined probability of capacity and likelihood of occurrence measures the vulnerability of the important intangibles.

Over-reliance on the science of valuation can be deceiving when not enough attention is paid to the art. If intangibles are not dealt with on a disaggregated basis and their vulnerability to loss assessed, the light of hindsight will reveal a reality surprisingly different from a purely methods-based valuation.

Harry J. Smith, CPA, MBA, CSA, CMA, is Managing Director of La. Nugenus Inc., a developer of family business succession planning software in New Orleans. He can be reached at 504.891. 1942 or [e-mail]. Timothy F. Smith, CFA, MBA, is a valuation professional in the Financial Advisory Services practice of investment bank Houlihan Lokey Howard & Zukin, in Atlanta. He can be reached at 404.495.7024 or [e-mail].