Although there are many factors to consider when valuing a business, there are particular nuances to contemplate with respect to private, owner-managed or family-managed companies. These can include, but are not limited to the following:
- Whether compensation is paid to family members, including those who do not actively participate in the business (i.e., income splitting);
- If there are transactions with related parties;
- The existence of non-operational assets or liabilities;
- Internal controls and governance policies; and
- Transferability of goodwill (i.e., personal goodwill vs. commercial goodwill).
Compensation paid to family members
It is typical for family-run businesses to employ family members throughout an organization, from the President to the administrative staff. As a result, it is critical to consider whether these family members are compensated at levels that are commensurate with market rates for the services they provide. It should also be noted that deviations can be found at both ends of the spectrum, both above and below market rates.
For instance, while a family member may occupy an administrative role at an above-market rate, the owner/President may work extended hours to perform several vital services and roles (e.g., operations manager, business development, supervisor) that would require multiple individuals to be hired to fulfill the vacated responsibilities. The market rates for multiple positions may suggest that the President’s compensation is a relative bargain.
In some cases, one or more family members may be compensated while doing little or no work for the business. This practice is often referred to as “income splitting”, where a portion of wages for a higher-earning family member (e.g., the owner) are paid to a spouse or child in order to capitalize on the lower effective personal income tax rates of those family members. Although the Canada Revenue Agency has implemented various rules to counteract or eliminate such practices, the consideration of income splitting remains relevant for valuations.
Furthermore, it is important to quantify the total compensation, including benefits and perks that may or may not be available to non-family members. Some of these include the use of employer-paid vehicles, club memberships, extended health plans, as well as non-business related travel, meals and entertainment expenses. For a business being valued using an approach based on earnings or cash flows, these elements must be considered to arrive at reasonable market rate adjustments to normalize operating results.
Related party transactions
Apart from employing family members, businesses may also engage in other transactions with related parties, such as rental contracts or supply commitments, amongst others.
Parties can be related in a number of ways, including companies with common ownership or those owned by other family members. For example, consider an operating company (the “OpCo”) that rents its office from a real estate holding company owned by the mother of the owner of the OpCo. The rental rate paid by the OpCo could be adjusted at year-end to smooth taxable income amongst the related companies. In another example, the OpCo purchases a significant portion of its materials from a supply company owned by a sibling, at below market prices.
In each case described above, a valuator will need to adjust cash flows to a market rate that reflects what a company would pay if it did not have access to such discretionary related party relationships.
Non-operating assets or liabilities
Particularly successful businesses may have built-up cash resources that allow for investments in assets that do not have a direct impact on the operating cash flows of a business. Consider investments in GICs, a stock portfolio, or vacant land. In other cases, the business may have outstanding amounts payable to one or more family members/shareholders. These non-operational assets and liabilities are considered redundant.
In a valuation, it is typically assumed that prior to a sale, such assets would be extracted, while the liabilities would be extinguished. As a result, a valuation will include calculations of a company’s value with and without such assets and liabilities.
Internal controls and governance
Since many family-run businesses employ multiple family members in various roles, there are often concerns regarding proper internal controls and governance policies. For instance, most businesses adopt a segregation of duties amongst the individuals responsible for revenue administration, such as billing, collections and deposits. Where a family business may be relatively under-staffed, to allow for assurance that the risk of misappropriation of funds would be sufficiently mitigated, the valuator may need to assess whether additional staffing costs should be factored into the maintainable operations were the business to be sold to an arm’s length party.
Transferability of goodwill and discounts for reliance on certain individuals
Most family businesses are controlled by one or a few family members who may be responsible for nearly all of the key relationships with customers and suppliers that form the foundation of the company’s operations. This is typically referred to as personal goodwill. In such situations it can be difficult to transfer some or all of the value of those relationships to an arm’s length purchaser, depending on the specific industry and other factors. This analysis can significantly impact the valuation methodology and the ultimate calculation of value.
Moreover, the reliance of a business on certain individuals may leave it particularly vulnerable to monetary loss, should those individuals depart from the business. The presence or lack thereof of employment contracts and life insurance policies will determine the impact of such issues on a valuation.
Do not hesitate to reach out to your professional advisors if any of these items appear to be relevant to your business. If you are considering buying or selling a business, or implementing succession and tax planning, our team at Grewal Guyatt LLP would be happy to provide a free consultation to discuss these and similar matters to ensure that you maximize your value according to your objectives.
Tom Strezos, CPA, CA, CBV, CFE, ASA
Valuations and Litigation Support
Direct: (905) 747-5162
Claudio Martellacci, CPA, CA, CBV
Manager – Valuations & Litigation Support
Direct: (905) 479-1700 ext. 4006