Buyout Boom is Receding, but Most Families Hold On
By Craig E. Aronoff, Ph.D.
Over the past several years, we’ve urged owners of family firms to become more sophisticated in their understanding of finance and financial terminology. To remain competitive in today’s marketplace, being good at producing or selling something is not enough – sophisticated financial management is increasingly a requirement. Consequently, family business executives and the shareholders they serve increasingly discuss liquidity, diversification, leverage, EBITDA, LIBOR, RONA, EVA and the many more obscure words and acronyms that comprise the vocabulary of finance.
Financial discussions in family business have also been driven by another factor – the amounts being paid for operating businesses. Driven by the same low interest rates and easy money that allowed home prices to balloon, business values leapt upward from their post–technology bubble, post-9/11 lows to unprecedented multiples in 2006 and early 2007. Folks who had never considered selling their family businesses were now at least willing to talk about the idea. They began to consider the security that conservatively invested cash could offer, sometimes for generations to come. Some imagined the relief of avoiding business risk, operational headaches and the capital requirements of growing enterprises. As prices peaked in mid-2007 and began to decline, and as the political climate seemed to suggest that the next move in capital gains taxes would be up, interest became more intense.
While most family owners haven’t sold, a few have taken advantage of the sellers’ markets to cash out. The vast majority of committed, long-term family business owners, have done what they have always done – found ways to keep the business in the family. But the discussion about finance and potentially selling the business has had many beneficial impacts. More owners are now cognizant of their business’s value and are more focused on building that value over the long term. The benefit of taking distributions and/or purchasing stock at a low point in value is better understood. As a result, many family businesses have developed dividend or distribution policies as well as mechanisms to fund limited opportunities for stockholders to sell shares. Recognizing the value of their shares has also motivated many owners to focus on their estate planning. Discussions of selling have in many cases reinforced family owners’ commitments to stay the course and to do those things necessary for long-term success.
Of course, all this discussion of selling, risk, value, strategy, estate planning and the like has engendered a fair amount of conflict within owner groups. Much conflict has been focused on the question of what one’s shares are “really worth.” Under such circumstances, conflict is to be expected – but I’ve observed that much discomfort is caused by the basic misunderstanding of a particular financial concept: the discounts that are applied in valuation of minority positions in closely held enterprises.
Most family business shareholders are first exposed to discounts in the course of estate planning. In the effort to minimize estate tax liability, estate planners and business valuation specialists drive down the appraised value of family business ownership by applying discounts for lack of control and lack of marketability to the price of minority ownership positions. Consequently, “discounts” are often viewed as a kind of legal mumbo jumbo designed for the sole purpose of keeping Uncle Sam’s mitts off our hard-earned cash. The documentation supporting these efforts, the valuation report, is a lengthy technical document that attempts to justify the values established, either for gifting or for estate planning.
As a result, discounts are often misunderstood and treated as something that is not “real.” The “real value” of a share of a family business is usually considered to be the price the company would fetch if sold, divided by the shares outstanding. That’s well and good – until the discussion turns to the desire of certain minority shareholders to cash out, insisting that they should get full, fair, real value. Their argument is countered by the valuation report, which discounts minority positions by 20–50% because minority shares do not convey the ability to control the business and because the shares are not easily sold.
I am currently working with a client who is considering offers either to buy the company outright or to buy a minority position in the company. The offers to buy the entire company average about 25% higher per share than the offers to buy a minority ownership position. When News Corp. recently purchased the Dow Jones Company, Inc., shares trading before the offer were valued in the low to mid $30s. Suddenly, the shares jumped 60%, a value that would only stand if Mr. Murdoch bought enough shares to control the company. The difference in price reflects the value of the control – or the lack thereof.
The point is that “market value” is “real” only if the company is being sold. The minority share value, factoring in lack of control and lack of marketability, is equally “real,” a reflection of the value of a share under different circumstances. “Discounting” is the process by which valuation experts estimate a minority share’s value when the business isn’t being sold. It does not mean that the discounted price is less “real” or “fair” or “full” under the circumstances. There is a real, fair, full market value per share when an entire company is being sold, and a different real, fair, full market value when a minority position is redeemed by the company because no one else wants to buy. Understanding that fact could reduce conflict and could quell a seller’s suspicion that the discussion of discounting, is an effort to take unfair advantage.
Blackstone Group, a private equity firm that went public in the midst of the recent leveraged buyout boom, has seen its own shares discounted 30% by the market since its IPO. Leveraged buyout-linked senior loans are trading at less than 90 cents on the dollar, according to The Wall Street Journal. The money and credit available to private equity and others doing the buyouts has waned. Prices reflected as multiples of cash flow or EBITDA have begun to recede. For some families, the boom provided a chance to cash out. For most others, the boom provided great opportunities for discussion and learning through which important decisions were made, strengthening businesses and owner families for the long term.
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