The Key to Succession Planning is Business Valuation

The Challenge of Succession

Many business owners dedicate their lives to building their enterprises. So, it stands to reason that when it comes to succession planning, they encounter the tough decision of whether to sell, dissolve or transfer their businesses to family members. Transferring a business involves navigating various complexities, such as dividing the family business logically, assigning value and addressing intricate tax issues.

The Role of Business Valuation

Succession planning requires a strategic approach, and engaging experienced financial advisors is paramount. At the core of this process is a comprehensive business valuation. By partnering with a skilled valuator, business owners gain a clear understanding of their company’s financial health and market standing. A thorough analysis of the company’s assets, liabilities, revenue streams and market position provides essential data for informed decision-making. Valuators collaborate closely with family business owners and legal counsel to develop tailored succession plans that address unique challenges and opportunities. Their expertise in determining the intrinsic value of the business is indispensable in achieving equitable outcomes for all stakeholders involved.

Economic Factors and Valuation

Economic conditions play a crucial role in determining value. Before outlining a succession plan, business owners, alongside their valuators, must consider how the economy impacts market value. Valuators strive for balanced assessments, avoiding excessive pessimism or optimism. Valuations that overlook the cyclical nature of economic conditions or double-count risk factors could lead to incorrect business value. Variables influencing value include:

• Expected cash flows: Future earnings dictate value according to both market and income valuation approaches. Changes in demand, pricing trends and adjustments to historical financial statements to reflect future expectations are essential considerations.
• Perceived risk: Higher risk results in increased discount rates (income approach) and lower pricing multiples (market approach), leading to lower values, and vice versa. Buyers like companies that are predictable, so the less risky you can make your operations, the higher value you will receive at a sale.
• Marketability: A marketability discount is intended to account for the reduced ability to convert an ownership interest into cash. An ownership interest in a business is worth less if it is not readily marketable. Given the option between two investments with equal return, a prudent investor will choose the investment with less risk. Part of that risk is inherent in the investor’s ability to quickly convert their investment into cash, which is the purpose of the marketability discount.

Valuation Discounts and Their Impact

Various factors affect the extent of valuation discounts, influencing the attractiveness of a business to potential buyers. Here’s a breakdown of how these factors contribute to the discount:

• Financial performance: A business with a consistent history of profitability and strong financials is generally valued higher than one with a history of losses or volatile performance. Investors appreciate companies who have predictable and consistent cash flow. Less volatility leads to less discount.
• Portfolio diversification: A business with a diversified customer base and product offering is generally considered less risky than one reliant on a single customer or product. Less risk translates to a lower discount.
• Leverage: The amount of debt a business carries (leverage) can affect its valuation. High debt levels increase the risk for potential buyers, leading to a higher discount.
• Owner rights: The rights and control granted to owners can influence valuation. Limited voting rights or restrictions on transferring ownership can decrease attractiveness and lead to a discount.
• Distribution history: The history of dividend payments or profit distributions can impact valuation. A consistent history of distributions indicates a business generates steady cash flow, which can be attractive to buyers and potentially reduce the discount.
• Personal characteristics of general partners or managing members: In closely held businesses, the experience, reputation and expertise of the key personnel can significantly impact valuation. The potential loss of these individuals could decrease the business’s value and lead to a higher discount.

Discounts can vary significantly depending on the specific circumstances of a business, potentially exceeding 40 percent of the entity’s net asset value. A thorough understanding of these factors is crucial for business owners and their advisors when determining the fair market value of a business for succession planning purposes.

Timing and Purpose of Valuation

The timing of business transfer also impacts valuation. Whether the owner transfers the business during their lifetime, at death or upon a spouse’s death carries significant value implications. For example, bequeathing the business to a spouse can defer estate tax until the spouse’s death, provided they are a U.S. citizen. However, the estate tax may be due upon the spouse’s death, contingent on the business’s value and prevailing tax laws.

Retirement and Succession

Another critical consideration is when or if the owner plans to retire. If the owner wishes their children to take over but requires cash for retirement, selling shares to successors or using trusts can offer tax advantages and aid in funding the business purchase.

The intended purpose of valuation significantly influences outcomes, particularly regarding heirs’ differing views on the business’s proper value. Inactive heirs, who won’t inherit the business, necessitate equitable share allocation with other assets like insurance proceeds or real estate. It is crucial for the expert to understand the valuation’s purpose and the owner’s estate plans.

Windham Brannon Knows Valuation and Succession

Implementing or revisiting succession plans is crucial for business owners to safeguard their enterprise’s future and prevent potential burdens on their families. Starting now with the guidance of a valuator ensures preparedness for future transitions and strengthens business continuity planning. Windham Brannon’s professionals know and understand the key role that valuation plays in your succession plan – our experts are ready to help you execute your vision for the future by showing you the key drivers of value of your business and building strategies for a smooth transition. For questions or more information, contact your Windham Brannon advisor, or reach out to Matt Stelzman.