The more expansive blend of interests characteristic of a family operation can also create confusion about value, Brownell says. Negotiations need to aim for a price that represents a win for outgoing and incoming family members, while also leaving sufficient reserves to sustain the business as an ongoing enterprise for the employees and the customers.
“The need to ensure that the business thrives and serves a mix of constituents means that the price will likely be a little bit lower than if the sale were to a third-party buyer,” Brownell says.
Some family businesses try to resolve such conflicts by inviting both sides to weigh in, adds Travis W. Harms, the leader of Mercer Capital’s Family Business Advisory Services Group.
“Many buy-sell agreements have provisions that call for both seller and buyer to get appraisals,” Harms says. “The idea is that if the two results differ within a specified percentage, then everyone agrees to accept an average of the two.”
Unfortunately, what seems on the surface like a good solution too often turns out to be yet another source of conflict. An appraiser will usually shade the business value assessment to reflect the interests of whoever is footing the bill.
“Once the parties are locked into a conflict, it is rare that the conclusions of the respective appraisers will be very close,” Harms says. “The upshot is that the business ends up hiring a third appraiser. Not only does this take time and money, but there is still plenty of room for argument. Inevitably, one or both parties will be unsatisfied, and that can lead to hard feelings and litigation.”
It’s tempting to try to head off these conflicts by designing a valuation formula agreeable to everyone, then setting it in stone for use later. But this also presents risks.
“While a clearly defined formula can avoid the problem of ambiguity, the problem is that industries, markets and business operations change over time,” Harms says. “A formula that makes sense today may not make sense five or 10 years down the road when the buy-sell agreement has to be used.”
Regular appraisals
The secret to success, consultants say, is to schedule periodic appraisals with parameters that are clear and acceptable to all family members.
“All parties should understand the approaches to value being used and the assumptions being made,” Harms says. “That will reduce uncertainty and cut down on the potential for conflict later when a trigger event occurs.”
How often should the appraisals be done? For the best results, consultants say the appraisal should be done annually.
“It’s a lot less expensive to do that than to deal with the costly infighting that can otherwise result,” says Z. Christopher Mercer, CEO of Mercer Capital in Memphis, Tennessee.
Periodic appraisals offer a fringe benefit: knowledge about a business’s confirmed value that can help manage the family wealth.
“Valuations can help family members understand the rate of return they’re receiving on their investment in their private company,” Mercer says. “And just like any other investment, that rate is based upon three points: a beginning value, an ending value and the interim distributions.”
Mercer offers an example: If a company stock valued at $100 one year increases to $112 a year later, then the shareholders enjoyed a 12 percent return on their investment. If the company also paid them a $3 distribution, then their total return on investment comes to 15 percent.
Funding the stock
Assessing the value of a family business is one thing. Scraping together sufficient cash to purchase a departing owner’s stock is another. Buy-sell agreements should address funding sources to obviate a lot of scrambling around when disaster strikes.
Insurance policies can provide funds for the purchase of shares in the event of death or disability.
“Very often, key person insurance can be taken out for individuals whose contribution to the business is so vital that if something were to happen to them, the operational and earnings capacity of the business would be unduly impacted,” Brownell says. “The policy can be structured to pay sufficient cash to either hire a replacement, offset lost income or purchase the insured’s stake in the business.”
Neither life nor disability insurance will help, though, for trigger events such as retirement, resignation, termination or divorce. In such cases, businesses can find themselves searching for alternative funding sources.
Perhaps the first solution that comes to mind is an outside lender. But, in many cases, that’s less than ideal.
“A business that borrows money may end up reducing its future capital expenditures or cutting back on mergers and acquisitions,” Harms says. “Those alternatives can have adverse consequences for the company down the road.”
Purchase of shares by a third party also has its downsides.
“Many family businesses are wary of bringing in non-family shareholders,” Harms says. “Anyone who invests money will want to exert their influence to make the company run the way they would like to see it run. That can create a whole host of unintended and potentially negative outcomes.”
