Why You Should Care About Your Business Value

Jeremy Glaser: For Morningstar.com I'm Jeremy Glaser. We often talk about stocks and bonds and other investments that are easy to check the price of, but what about less liquid investments, such as a family business. I am here today with Morningstar's Director of Valuation, Alfonso Ventoso to take a look at some of these questions.

Alfonso, thanks for joining me today.

Alfonso Ventoso: Thank you.

Glaser: So, what are some of the reasons that people don't check to see what the value of one of their family business would be?

Alfonso Ventoso: Business owners are kind of ultimate investors. They didn't just write a check and buy a stock or bond, and as you said in your introduction, that's what we spend most of our time thinking about. But for most business owners, the illiquid asset of their business represents the majority of their net worth. The reason that a lot of them don't pay attention to the valuation is that they are busy running and growing their businesses, which is what they've been doing for, in some cases, decades pouring their heart and soul into the business. That's why it's called sweat equity.

And no one is asking them the important questions, which are, how much longer do you want to work? Is the liquidity event of your business going to be enough for you to retire on? And what's your exit plan? In other words, who do you want to sell to? And there is an extension to the last question, which break downs between, do you want to sell the business to a third-party buyer and maximize your income or do you want to keep it in the family and create a legacy?

Glaser: So you have all these questions, but why would someone care. We always say you shouldn't check your portfolio everyday. Why would it matter exactly how much it's worth at any given point in time?

Ventoso: Because if you've been running a business from inception to fast forward a decade or two later and you've got 50 or 500 employees and millions of dollars in revenues, a lot of people value their businesses based on a rule of thumb. And they figure its worth x-times earnings or x-times revenue, but a lot of the time those rules of thumb are misguided. And so, when it does come time for a triggering event, it happens that someone has to react to, they are woefully uninformed, sometimes by orders of magnitude as to the true value of their business.

So, we are not saying they have to have a valuation to another private business every month or even every year, but certainly every couple of years. It will help them kind of understand the trajectory towards that exit.

Glaser: What are some of those trigger events?

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Ventoso: They are all sorts, if a business owner is proactive in thinking about exit planning you can end up creating one of two trigger events. Either an estate planning-like event, that says we are keeping it in the family, and we need to do some planning around that. Or an M&A event, which says, we're going to sell the company, and we need to prepare the company for that.

From a reactive perspective, you've often got the retirement of one or more shareholders. Let's say there are five shareholders in the company and the first guy wants to get out, everybody else is going to want that to be a fair value. They want to be left holding the bag. Similarly, the guy leaving the business wants to make sure that he is getting a fair shake.

Other events include more operational events. Employee stock option plans are put in place, you need to know what the company's worth, in that case or an ESOP, an employee stock ownership plan. And then finally, there is sort of the unpleasant life events like death, divorce and taxes, that all, in different ways, generate the need for valuation.

Glaser: So, what's some of process of getting the valuation? As you said just multiples don't work very well, what are some of things people want to be thinking about in valuation?

Ventoso: Actually, they often get conflicting advise from a valuation consultant when compared to the advise that their accountant gives them. Accounts often advise private business owners to minimize their reported income because of tax efficiency. When we go in there and we're trying to value a business and look at it as a third party buyer, we look at it – we remove a lot of discretionary expenses and any owner income beyond what an employee would be paid is actually a profit. So, when we go in there to do that analysis, we're often looking at maximizing cash flows as opposed to minimizing profit.

Glaser: So, once you find out about the valuation of your business, how would that impact your decisions across the rest of your portfolio, so your stocks, your bonds, and your traditional investments?

Ventoso: We sort of look at it as three levels, and sort of a three layered, dark bordered doughnut. In the middle, you've got your stocks, bonds and your cash, which is again, as we said, what most people spend their time thinking about, let's say that's a $1 million. Then you've got your other concerns, such as college education, real estate, sick parents, medical care and things like that.

A holistic financial planner will, if a client is lucky, will be dealing with the first tenant, the nucleus there and then the out layer of concerns. But really the business often ends up being the wrapper of the whole thing, some times 10 times the value of all those other things combined. And so, once someone is aware in this example, that their liquid portfolio is worth $1 million, but business is worth $10 million, they tend to look at things differently and tend to start to get concerned about funding retirement and funding future expenses and just start to think about things differently.

And that can help. The sooner the better. If you are three to five years away from any kind of liquidity event, you can do a lot of planning around trying to optimize the exit from the business.

Glaser: So, certainly the valuation is going to impact your decisions elsewhere?

Ventoso: Absolutely, yes. And these days we're seeing a definite, what we call, value gap between, everyone thinks they have the prettiest baby or the best house on the block, and a lot of people are misguided about what they think their business might be worth. Because of this emotional attachment that they've been pouring into it for years. And when we go in there, if we are early enough, we can tell them hey, your business maybe isn't that special, it looks like a lot of other businesses other there. But here is what you can do over the next few years to improve that picture.

Glaser: Alfonso, thanks for taking the timing the talking to me today.

Ventoso: Thank you.

Glaser: For Morningstar.com I am Jeremy Glaser.