Family BusinessOctober 5, 2020by Business Valuation TeamMain Considerations When Valuing a Family Owned Private Company

Business valuation is a complex process, and it is easy to miss certain components, especially when the considerations vary with the type of business.

There are things to note specifically for a valuation of family owned businesses.

The Relevant Concepts To Note When Valuing A Family Owned Business Are Listed As Follows:

Fair Market Value

When a business has more than one buyer, each having an equal opportunity (i.e. the relevant financial data and support) for the purchase, there is competition – or a market – for the business. The situation then calls for a ‘fair market value’.

A fair market value assumes the buyer’s point of view, and essentially answers the question: how much would a neutral third party buyer be willing to pay to gain ownership of the shares and assets of a particular business?

A usual request would be to work out the fair market value of a business based on the notional value of its shares or assets, which is determined in the absence of an actual trading.

Minority Discount

Suppose a business’s fair market value is $10,000,00, and a particular shareholder holds 10% of the business’s shares, then this shareholder would be holding onto $1 million worth of shares.

Unfortunately, this is not how it works.

Since the shareholder is considered a minority one, he/she has no say in directing the business, and hence no say in the amount received for his/her shares.

So a minority shareholder with 10% of the voting shares would have a very insignificant role in deciding the management team, investment directions, assets to own, employee salaries and other operation matters of the business.

In view of this, a buyer of the business is likely to be willing to pay less than $1 million for this 10% of ownership. The difference between this and the ideal $1 million is then called the ‘minority discount’; and it is usually fluid.

So should a buyer offer $400,000 for the 10% of shares, then the minority discount would then be $600,000 (or 60%).

Fair Business Value

For private businesses, its ‘fair value’ is the fair market value excluding the minority discount or premium. This definition is often used when the ultimate aim is to achieve fairness, usually in a legal setting involving a marriage – it is considered unfair for one of the sides to receive a huge minority discount.

Without marriage in the background of a legal settlement, such as a shareholder dispute, the same concern with minority discount becomes invalid.

It is noteworthy that such views may be different by the Inland Revenue Authority of Singapore (IRAS). Specific details will not be discussed here.

Often, the courts, IRAS and the buyers would have different opinions about a business value hence the valuer would need to first ascertain the users of the valuation report, and then set proper and relevant guidelines to communicate for adherence.

Shareholder Agreement

A shareholder agreement for privately owned business should explicitly state the mutually agreed terms and conditions for minority discounts. Hence it should readily answer – or provide a clear direction to – questions like ‘Should a withdrawing minority shareholder be given a minority discount?’.

In fact, there are family owned private businesses with shareholders mutually consenting to not consider the minority discount when they buy back the shares from a withdrawing minority shareholder.

A mention on minority discount in a shareholder agreement helps a lot on the impending transactions. It would help a great deal more when the agreement specifies a valuation method or indicate that the value of the business equity interest will be ‘as determined by the independent valuer’. This will avoid using formulae that will incur undesirable outcomes.

Valuation Method

A business has to be confirmed ‘a going concern’ before proceeding with its valuation.

For businesses that are a going concern, the valuer will use the appropriate valuation methods such as the net assets approach and the capitalized approach.

Otherwise, the valuer will use the numerous liquidation approaches he/she is familiar with.

Net Assets Approach

This method is not for businesses with ‘goodwill’ in its assets.

The net assets approach depends on the fundamental – or underlying – value of assets, which is usually for the valuation of holding companies, including the ones dealing with real estate.

Capitalized Earnings Approach

This method is often used for businesses with more gains generated from its size, processes, management team and other operation aspects, than from its assets alone. This can be determined through analysing the business’s income, the market perception and the risk of cash flow disruption.

Suppose a business yields an income of $1,000,000. Based on the buyers’ evaluation of the business and its risks of cash flow disruption, the rate of returns is 20% per annum, and its fair market value is then $5 million (5 times the income, from 1 divided by 0.2 or 20%).

Should the fair market value of its assets, excluding the liabilities, amount to $4.2 million, then there will be a goodwill of $800,000.

The above shows that the capitalized earnings approach would require much effort in working out the proper income and rate of returns (based on the appropriate risks) to reach a conclusion.

As the above are merely concepts based on general circumstances, it would be useful to clarify with the valuer on your specific situation or when there are exceptional circumstances.

Speak with a specialist valuer in Singapore today.