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?

2
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, francesco.bavagnoli@eco.unipmn.it
Università del Piemonte Orientale
Dipartimento di Studi per l’Economia e l’Impresa
Department of Business and Economics
Novara, Italia

3
AffiliationAffiliation
Università del Piemonte Orientale
Department of Business and Economics,
Novara, Italy, www.eco.unipmn.it

4
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 ?

5
AbstractAbstract
We 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

6
Introduction and contextIntroduction and 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

7
Future
Income
Assets and
Liabilites
Financial
Markets
Bavagnoli (2012)
A compass for firm valuationA compass for firm valuation

8
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

9
• 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)

10
• 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

11
• 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

12
• 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
Stagnationtheory

13
- bright side of family business- bright side of family business

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- dark side of family business- dark side of family business

15
- 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)

16
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

17
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)

18
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

19
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

20
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

21
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)

22
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

23
RiskRisk
- the governance challenge- the governance challenge
• Management and ownership structure
Traits of management and governance Risk
Nepotism: 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 know ledge 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 passage
of time
+
Entitlement culture: unsustainable culture of acquisition and consumption +
Confusion between firm and family, Intermingling of personal expenses
with business expenses, Asymmetric altruism (towards family members at
the 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 allow
outsiders to hold equity)
+

24
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)

25
RiskRisk
• 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

26
RiskRisk
• 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)

27
RiskRisk
- access to finance- access to finance
• IVSC, 2013, Exposure Draft, Bases of value

28
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

29
Financial MarketsFinancial Markets
- family premium or discount ?- family premium or 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

30
• 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

31
• 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

32
• 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

33
• 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

34
Expected signs of beta coefficients in an asset side regression of
the EV/Sales multiples observed in private equity deals
Variable 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 riskier
Accounting beta - Measure of risk, inversely related with value
Market 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

35
• 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

36
Conclusions:Conclusions:
- specific challenges in family firms valuation- specific challenges in family firms 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

37
- possible biases in family firms valuation- possible biases in family firms valuation
• 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

38
• 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

39
• 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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