What Should We Do Different when We Value a Privately Held Family Business ?

Company Valuation & Family Business

III International Symposium

24-25 April

Universidad de Almería

What Should We Do Different when We Value a Privately Held Family

Business?

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AuthorsAuthors

Francesco Bavagnoli*, Researcher with teaching aggregation, CPA, Auditor

Maurizio Comoli, Full Professor, CPA, Auditor

Lorenzo Gelmini, Researcher with teaching aggregation, CPA, Auditor

Patrizia Riva, Ph.D., Researcher with teaching aggregation, CPA, Auditor

*contact person and presenter, [email protected]

Università del Piemonte Orientale

Dipartimento di Studi per l’Economia e l’Impresa

Department of Business and Economics

Novara, Italia

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AffiliationAffiliation

Università del Piemonte OrientaleDepartment of Business and Economics,Novara, Italy, www.eco.unipmn.it

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AbstractAbstract• The academic literature on family business has devoted a lot of attention to define the uniqueness of family firms often emphasizing their outperformance compared to their non family equivalents

• But what are the practical insights that the professional valuer can take away and put in practice when she performs the valuation of a privately held family firm ?

And, in particular, in a market value perspective:

• is there a family premium or discount ?

• the strong influence of the family on the business does expose the firm to some additional risk ?

• are there any specific valuation biases in the family business context ?

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AbstractAbstractWe suggest that:• it’s not possible to argue in absolute terms that there should be a market premium or discount for family firms• the valuer should pay attention to the nature of the relationship between the firm and the family as long as there is a dark side and a bright side of the influence of the family on business• some quantitative analysis may be useful to understand how the specific characteristics of family firms may influence their riskiness especially from a potential buyer’s perspective and discriminating between potential buyers interested in minority vs control stakes• some biases in the valuation process may be relevant in the family business context: confirmation bias, halo effect and anchoring

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Introduction and Introduction and context context • More likely than not, in a typical valuation engagement, we are valuing a family business• We refer to the assessment of the market value of a privately held family firm performed by an independent expert• Market value is defined by the International Valuation Standards Council (IVSC) as the estimated amount for which an asset (or liability) should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion• market value: financial value, in a market participants perspective, value non entity specific • market value doesn’t include socioemotional value

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Future Income

Assets and Liabilites

Financial Markets

Bavagnoli (2012)

A compass for firm valuationA compass for firm valuation

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Future income: Future income: - family business performance- family business performance• family businesses perform better or worse than non family ones ?• some studies emphasised the overperfomance of family businesses, but the results: • are controversial and put in question by other researcher• depend on the definition of family firms (definition dilemma)• are confined to the universe of listed companies (for private firms studies do not point in a precise direction)• moreover, even the most rigorous and cited studies manage to explain just a little fraction of the performance of the business even if they account for a lot of variables normally considered relevant by a professional valuer

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Future income: Future income: - family business performance- family business performance• most cited study: Anderson & Reeb, 2003 • better performance (in terms of Tobin’s Q and Return on Assets) of US listed firms where the founder’s family retained any percentage of the capital and (or) a member of the founder’s family held a position in the board of directors • methodology: return on Assets and Tobin’s Q are regressed on 3 family variables (Family firm / Young-Old Family Firm / CEO hired-founder-descendant), control variables for each year and sector and 9 other independent variables highly relevant for valuation models such as R&D/Sales, LT debt/Total assets, Past Return Volatility, Dimension (Total Assets)

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Future income: Future income: - family business performance- family business performance• most cited study: Anderson & Reeb, 2003 • explanatory power (R square) 27,6%-36,5% ROA regression, 41,1%-41,16% for Tobin’s Q regression• the Authors cannot rule out an endogeneity problem, i.e. family ownership and family involvement in the board, high R&D/sales indices, low leverages, presence of independent directors, equity based CEO pay may be the result and not the cause of better performance

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Future income: Future income: - family business performance- family business performance

• conclusively, after examination of these studies:• a professional valuer should not even have a bias (regarding an expected better or worse performance) when valuing a family business, and • these studies cannot substitute for a careful analysis of the firm’s fundamentals: cash flows, growth and risk (Damodaran, 2012) especially if we look at the private equity universe where evidence is not clear at all and the explanatory power of regression models has proven to be even lower

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Future income: Future income: - family business performance- family business performance• an important contribution for the professional valuer may come from other studies which have shown the most common virtues and defects of family firms

Bright side

Stewardship

theory

Agency theory

Patient capital

Dark side

Stagnation theory

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Future income: Future income: - bright side of family business- bright side of family business

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Future income: Future income: - dark side of family business- dark side of family business

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Future income: Future income: - quality of forecasts- quality of forecasts• important attribute to be assesed by the professional valuer• IVSC, 2013, Technical Information Paper, Discounted Cash Flow, if the management’s forecast correctly represents the probability-weighted average of all possible cash flows the discount rate can be determined using the standard CAPM / WACC formula, otherwise if the forecasts are overly optimistic the discount rate shall include an additional risk • bright side of FB: a family owner and manager has a deeper knowledge of her business and can make forecasts of better quality• dark side of FB: if the business is not open to professional managers forecasts are likely to be less accurate also because family managers may lack the required skills to produce them• practical insight: assess the skills of the management and their past track record in making good/bad predictions (as per IAS 36, par. 34)

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RiskRisk- cost of equity- cost of equity• formulas and points made by academics:• standard CAPM formula (Ke = rf + β * ERP) adjusted for an additional illiquidity premium and multiplied by a factor (1 – FE), FE = Family Effect ranging from 0 for a litigious owner family to 1 in case of the group living in perfect harmony (in this latter case cost of equity = 0% !)• cost of equity for family firms is relatively lower, because:• the firm has not just a financial value for the family owner but also an emotional value • equity holders are available to give up current dividends in exchange of family harmony and security of control• the patient attitude of family capital allows the firm to adopt a longer time horizon which eventually reduces risk even if the firm tends to embark on riskier projects

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RiskRisk- cost of equity- cost of equity• the arguments advanced are fascinating and may help to explain the typical unwillingness to sell (or to let go for the old founder in charge of the operations) of family owners, but:• if we want to assess the market value of a firm (which is not entity specific) it is not appropriate to consider the lower expectations of return or the higher propensity to risk of the current owner if those are not characteristics attributable also to the typical market participants• a quantitative approach may be used to asses the objective riskiness of family vs non family business as perceived by market participants (see next slide)

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RiskRisk- quantitative approach- quantitative approach• Compare the explanatory power of two regression models• A) For listed companies• First model: regression of CAPM beta on variables such as financial leverage, operating leverage, growth, dividend payout, earnings volatility, liquidity, size, book-to-market (inverse of P/BV), earnings co-variability (accounting beta) • Second model: inclusion in the regression model of additional explanatory variables such as family involvement in ownership, control and/or management

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RiskRisk- quantitative approach- quantitative approach• Compare the explanatory power of two regression models• B) Non listed companies• First model: regression of accounting beta calculated as covariance of firm’s ROE with market’s ROE scaled by variance of market’s ROE (or firm’s and market’s ROI in an unlevered version) on variables such as financial and operating leverage, growth, dividend payout, liquidity, size• Second model: inclusion in the regression model of additional explanatory variables such as family involvement in ownership, control and/or management

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RiskRisk- a qualitative approach- a qualitative approach• from a fundamentalist investor point of view (know what you buy, beware of paying too much) which has to be incorporated in a market value assessment what interests is not a general relation but an accurate assessment of the specific risk profile of the firm and how the family may increase or mitigate the risk of the firm’s operations• therefore a qualitative approach may be more appropriate focusing on some specific family issues

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RiskRisk- qualitative beta- qualitative beta

Risk Weigh-Weight score ted risk

Industry 25% 5 1,25 Operating Leverage 10% 4 0,40 Management 10% 1 0,10 Currency and interest risk 5% 2 0,10 Country risk 15% 4 0,60 Earnings volatility 5% 3 0,15 Financial leverage 15% 2 0,30 Liquidity 5% 5 0,25 Access to finance 5% 3 0,15 Ownership structure 2% 4 0,08 Strategy 3% 4 0,12

100% 3,50 0,50 1,75 A x B = Beta

• adaptation from Fernández (2012)

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RiskRisk- qualitative beta: family issues- qualitative beta: family issues• Industry, Operating leverage and Strategy:• family firms may have a longer investment horizon and pursue a different strategy compared to their non-family counterparts embarking on riskier investment being equal the return or accepting lower returns the risk being equal (Zellweger, 2007, Poza & Daugherty, 2014) • this may imply a higher degree of operating leverage, i.e. the firm is committed to pursue business projects which generate high fixed costs with little flexibility to scale down the operations and cut expenses if the expected volumes are not realized

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RiskRisk- the governance challenge- the governance challenge• Management and ownership structureTraits of management and governance RiskNepotism: family first attitude in selecting managers +Strong family values and culture, harmony in the family -Stable relationships with all relevant stakeholders (shareholders,employees, clients, suppliers, banks, public bodies)

-

Profound knowledge of the industry developed in a long period of time -High dependence on the founder or key family figures +Family conflicts arising from dispersion of equity stakes and the passageof time

+

Entitlement culture: unsustainable culture of acquisition and consumption +Confusion between firm and family, Intermingling of personal expenseswith business expenses, Asymmetric altruism (towards family members atthe expense of outsiders) and Lack of transparency

+

Insufficient professionalization and access to a small pool of talents +Restricted access to capital to support growth (unwillingness to allowoutsiders to hold equity)

+

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RiskRisk- the governance challenge- the governance challenge• Management and ownership structure• possible different perception of the above mentioned items by a potential investor interested in the acquisition of a majority or a minority stake• the minority stake potential acquirer is exposed to the risk of being subject to the negative features of family governance (nepotism, asymmetric altruism, conflicts, intermingling) • the majority stake potential acquirer is exposed to the risk of losing the positive ones (unique skills of the founder family, social and commercial network, cohesion of equity holders, strong and accepted leadership)

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RiskRisk- qualitative beta: family - qualitative beta: family issuesissues• Liquidity• affects mainly (or exclusively) the minority shares and less significantly (or not at all) the control stakes • liquidity risk for a minority shareholder may be tempered• (a) by a tag-along right (if the majority shareholder sells her stake, minority equity holders have the right to join the deal at the same terms and conditions) • (b) by a liquidation plan set up by the family in order to provide family members (and/or outsiders) with the possibility of liquidating their assets at fixed dates

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RiskRisk- qualitative beta: family - qualitative beta: family issuesissues• Access to finance• in the family business literature, the particular attitude of the owner family (long-term horizon, patient capital, emotional attachment to the firm, intention to transfer the business to the next generation, reluctance to let outsiders acquire equity stakes) is more often than not viewed as a positive characteristic• keeping outsiders out, though, may prevent firm from growing and from making the most of business opportunities if the banks are not willing and the family cannot afford to finance new investments• the latter view seems dominant in the professional valuer’s eye (see IVSC example next slide)

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RiskRisk- access to finance- access to finance

• IVSC, 2013, Exposure Draft, Bases of value

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Assets and liabilitiesAssets and liabilities• Adjustments required for “Family” accounting • confusion and blurred boundaries between the family’s and the firm’s properties, rights and liabilities• assets held by the firm just for the family’s benefit or to satisfy a prestige need (such as apartments, cars, boats) or unfair salaries and perks for family members• for a minority shareholder, non operating assets held just for the family’s benefit represent an inefficient way to allocate capital and additional expenses (discount on the firm’s market value)• for a potential acquirer of a control stake the presence of non-operating “family” assets may not imply a discount because after the completion of the deal they would be free to decide whether to keep the assets or to liquidate them and would be able to review the remuneration packages of all the executives

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Financial MarketsFinancial Markets- family premium or - family premium or discount ?discount ?• data directly observable in the market • at the top of IAS/IFRS hierarchy amongst input data for fair value measurement (level 1 / level 2 inputs as per IFRS 13)• academic research has devoted particular attention to the notion of total value to the owner (subjective value) of family business which is financial value (including the value of private financial benefits for the family) plus a socio-emotional value• not equal attention has been paid to the investigation of the market value of family vs non family businesses especially in the subset of private companies

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Financial MarketsFinancial Markets- family premium or - family premium or discount ?discount ?• research gap: how the characteristics of family firms reflect on prices in real market deals ?• in the subset of private companies the research is still at the beginning • Granata, & Chirico (2010) have examined 73 pairs of deals in the Food & Drink Industry in the period between 2000 and 2008 and found that family firms traded at lower EBITDA multiples than non family firms thus implying a discount in the market perspective for family businesses • we could start to address this research gap collecting data on private equity transactions and testing some hypotheses which would discriminate between majority and minority stakes deals

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Financial MarketsFinancial Markets- family premium or - family premium or discount ?discount ?• Hypothesis 1 (expected family premium for majority stakes deals)• In transfers of majority stakes we expect there to be a family premium because the owner places an additional socio emotional value on the firm and requires a compensation to separate herself from the firm. Moreover the buyer will not suffer from the lack of transparency in the firm’s management and from the asymmetric altruism because they will be able to control directly the operations after the deal’s completion

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Financial MarketsFinancial Markets- family premium or - family premium or discount ?discount ?• Hypothesis 2 (expected family discount for minority stakes deals)• In transfers of minority stakes we expect there to be a family discount, because if the family keeps control of the business there will not be a premium to compensate the loss of emotional value and the buyer will be exposed to the risk of opportunistic behavior of family directors and managers in favor of other family members and to the lack of transparency/opaque management style

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Financial MarketsFinancial Markets- family premium or - family premium or discount ?discount ?• research methodology: collection of two separate data sets of market multiples regarding minority / majority deals and construction of two regression models assuming as dependent variable asset side multiples (EV/Sales, or EV/EBITDA) or equity side multiples (P/BV)• example:• First model (expected to explain a good portion of the multiple’s variability), regression equation:• EV/Sales = α + β1 (average of EBITDA/Sales in the 3 years before the deal) + β2 (average growth of sales in the 3 years before the deal) + β3 (dimension variable: number of employees) + β4 (leverage) + β5 (accounting beta or total accounting beta) + β6 (market mean of EV/Sales multiple of the precedent semester) +β7 (dummy variable high quality of the accounts and audit)+ β8 (number of board members)+ ε

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Financial MarketsFinancial Markets- family premium or - family premium or discount ?discount ? Expected signs of beta coefficients in an asset side

regression of the EV/Sales multiples observed in private equity dealsVariable Expected Rationale

Sign (+/ -)

Average trailing EBITDA/Sales +The higher the percentage margin the bigger the net cash flows originated by sales

Average growth of sales last 3 years

+If a firm’s achieved growth in the past it is expected to be able to keep on growing (even if it may be also the opposite)

Dimension: number of employees + Bigger enterprises are less risky

Leverage - More leveraged firms are riskierAccounting beta - Measure of risk, inversely related with valueMarket mean of EV/Sales multiple observed in deals executed in the precedent semester

+Direct relation with overall market (bullish or bearish) sentiment

High quality of the accounts and audit

+Transparency of accounting and quality of audit reduce the risk and the asymmetry of information for the investor

Number of board member +More components of the board grant a better decision making process

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Financial MarketsFinancial Markets- family premium or - family premium or discount ?discount ?• The following step is to build an alternative regression models including familiness variables such as family involvement in ownership, control and/or management in order to see if those variables help to better explain the variability of multiples observed in the markets and to • check if the involvement of the family in ownership and/or in the board and in the management of the firm triggers a premium (for control deals) or a discount (for minority deals)• control variables could also be added for turnaround deals and for distressed companies

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Conclusions: Conclusions: - specific challenges in family firms - specific challenges in family firms valuation valuation • it is not possible to argue in absolute terms that the market should assign a premium or a discount to family firms• a relevant contribution from the literature, in the professional valuer’s perspective, comes from the identification of the factors that can make the family a benefit or a hazard for the business (the dark side vs the bright side of family business)• some quantitative analysis may be useful in order to better understand how the specific characteristics of family firms may influence their riskiness (and their value) in particular in the perspective of a potential acquirer, discriminating between a minority vs majority stake deal

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Conclusions: Conclusions: - possible biases in family firms - possible biases in family firms valuationvaluation

• confirmation bias, if the valuer has a preconception of family firms to be better or worse than non-family businesses she will look for a confirmation

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Conclusions: Conclusions: - possible biases in family firms - possible biases in family firms valuation valuation

• halo effect, the valuer may confound the family and the firm and be influenced by the positive or negative characteristics of the family attributing them to the business

=

• harmony in the family doesn’t guarantee success

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Conclusions: Conclusions: - possible biases in family firms - possible biases in family firms valuation valuation

• anchoring: due also to social pressure, in a family business context the valuer, especially if she feels an emotional proximity to the owner family, may be easily captured by the family’s views and perceptions and frame the valuation according to the value expectations brought forward by the family

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