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The 7 Benefits of Annual Valuations
Most owners of privately-held
businesses believe that they know what their
company is worth. As they have worked to build
the business, often from the ground up, they
feel that their intuitive value conclusions
accurately reflect the fair market value of the
firm. In many cases, these business owners are
biased in their views towards the firm, and
therefore, have an inflated sense of value
associated with the business. Though a business
owner has their own opinion as to what the
business is worth, their value may differ
substantially from the value that could be
realized in an arms length transaction between a
willing buyer and a willing seller. Without a
formal valuation of the company, the business
owner often has nothing other than a gut feeling
to support the value that they attach to the
business.
Many business owners are reluctant to
hire an independent valuation professional to
conduct an initial valuation of the company (let
alone an annual valuation) if they do not
perceive the need for one. In many cases, there
is little perceived need for the owner of a very
small business to have a valuation performed,
unless of course the owner plans to leave the
business to children, needs a loan from a bank
when the company’s assets alone cannot support
the loan, or seeks to sell all or part of the
business. These business owners often are
individuals who have started or acquired a
“lifestyle” business—a business that provides
the owner with a job and enables the owner to
maintain their desired lifestyle. The lifestyle
business could be thought of as a hobby for the
business owner—a hobby that earns the owner
money.
As compared to a lifestyle firm, some
entrepreneurs seek to establish a
transgenerational enterprise—a firm that is
skillfully managed to create long-term value and
wealth for successive generations. These firms
typically exhibit the same seven characteristics
of successful transgenerational enterprises—a
compelling vision, professionalized management
team, a long-term ownership plan/strategy,
effective communication, good corporate
governance, a clear succession plan, and a
comprehensive strategic plan. As a result of
the need to ensure and evaluate successful
creation of transgenerational wealth, many
privately-held and family-owned businesses,
particularly those that have survived multiple
generational transfers, have instituted a policy
of having an independent business
appraiser/financial analyst conduct an annual
valuation of the firm.
Many firms of various sizes and
different phases of the corporate life cycle
have recognized the benefits of having an annual
valuation conducted. The most commonly cited
benefits of an annual valuation policy include
the following:
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Accountability and Performance—An
annual valuation of a privately-held firm
enables the shareholders to see the value
that is being consistently created or
destroyed by the management of the firm in
its execution of the corporate strategic
plan. Over time, if the executive
management of the firm consistently fails to
create value through the increase in the
estimated fair market value of the company’s
shares, the shareholders may seek to replace
the management team with a group more
capable of executing the strategy and
creating value for the shareholders. In
addition, an annual valuation may enable the
shareholders to identify the need for
substantial change to the strategic plan if
that plan consistently fails to create the
level of value anticipated. Overall, the
annual valuation promotes accountability and
provides clear performance
measurement.
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Estate Planning Purposes—Many
shareholders in privately-held
transgenerational enterprises have on-going
estate planning strategies aimed at
protecting wealth for heirs. As part of an
estate plan, a shareholder may periodically
place shares into a family limited
partnership whose shares are then gifted to
the shareholder’s children. A shareholder
may also make gifts of shares to the
children each year for tax purposes. In
order to facilitate this, an annual
valuation of the privately-held enterprise
provides the shareholders with part of the
data necessary for these estate planning
purposes.
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Buy-sell agreements—In
multi-shareholder firms, a buy-sell
agreement is an effective and practical
means of establishing how the buyout of
other shareholders will be conducted.
Though many buy-sell agreements have a
defined method or process for establishing
the value of the firm’s shares, an annual
valuation sets a clear precedent for the
methodology used to establish the value of
the shares. For those firms that do not
have buy-sell agreements in place, annual
valuations are a good way of avoiding (or at
least, tempering) disputes that may arise
when a shareholder seeks to sell his shares
to the other shareholders. Whereas one time
valuations can be open to criticism of bias
in favor of one party or the other, an
annual valuation tends to limit this
accusation as the methodology has been
applied consistently in previous years.
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Promotes Effective Communication—An
annual valuation of a privately-held firm is
an effective means of communicating value
creation between the executive management,
board of directors, and the shareholders of
the firm. The valuation may be the catalyst
for open discussion between the management
and the shareholders on issues related to
the strategic plan, succession plan,
financial objectives, return expectations,
etc. In addition, an annual valuation is a
good way for the management and board of
directors of the company to provide
value-added services for the shareholders.
This in turn can foster the creation of
goodwill between the management of the firm
and the shareholders, which may ultimately
lower the firm’s overall cost of capital.
The lower cost of capital may enable the
firm to invest in value-creating projects
that create long-term wealth for
shareholders—projects that may have been
overlooked in the past as a result of a
higher cost of capital.
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Facilitate Banking—Many
privately-held firms effectively utilize
leverage to invest in value-creating
projects. Often times, this leverage may
exceed the credit available based on the
firm’s fixed assets alone. In some cases,
the financial institution may be willing to
lend against the company’s goodwill, which
is identified in the process of a formal
valuation. The ability, then, of a
privately-held firm to borrow based on the
value of the goodwill or the value of the
company’s shares may expand the universe of
value-creating investment options available
to the firm. In addition, the annual
valuation may establish a track record of
value creation which could be used to
facilitate a recapitalization of the firm,
enabling management to further seek
value-creating projects, distribute funds to
the shareholders via special dividends, etc.
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Expands the Investment Options—Privately-held
firms, unlike publicly-traded counterparts,
suffer from a lack of liquidity and the
inability to use the company’s shares as
currency when seeking acquisitions or
mergers. An annual valuation that clearly
establishes a trend in value creation may
enable the management of the company to use
the shares as acquisition currency for
another privately-held company. The annual
valuation is also beneficial in the
shareholders’ investment decision making
process with respect to maintaining the
status of the company or seeking liquidity
through a merger or sale of the company.
The history of annual valuations may provide
the shareholders with a foundation for
negotiation of more favorable deal terms.
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Cost Benefit—Annual
valuations may also provide the company with
cost benefits as compared to one-off
valuations performed every few years. Many
valuation firms charge reduced fees for the
annual update to a valuation as part of an
ongoing valuation process for a
privately-held business. For example,
suppose that Triumvirate Industries, a
privately-held company with $25 million in
annual revenues, chooses to have a valuation
performed once every five years. The
valuation firm’s fee is set at $20,000 per
valuation. However, suppose that
Triumvirate Industries has an annual
valuation conducted. Whereas the initial
valuation fee may be $20,000, the subsequent
annual updates are $14,000. While the fee
structure varies by firm and by project,
annual valuation updates typically carry a
lower cost than one-off valuations.
As can be seen from the previous
discussion, there are a number of benefits
associated with a privately-held firm
instituting an annual valuation policy. While
this is most typical with large,
transgenerational enterprises, privately-held
firms of all sizes may derive some benefit from
annual valuations—whether it relates to
financing purposes, estate planning, or the
enlightenment of the owners in how they are
creating value within their firm. Those firms
that have been most successful in creating
long-term shareholder value and
transgenerational wealth have exhibited seven
common characteristics, as previously
discussed. Those firms that have instituted
annual valuation policies have likely added
value to the firm from one of the previous seven
benefits. In the end, the best way of measuring
the value that management has created for the
shareholders of a privately-held business,
particularly a transgenerational enterprise, is
through annual valuations conducted by an
independent valuation professional.
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