Valuation Formula or Third-Party Appraisal: What’s Right for Your Firm?
There’s no one answer to how to value your company’s shares, but failure to have a well-grounded method in your buy-sell agreement can cause long-lasting problems, not least creating fodder for potentially severe arguments among the partners and owners. A good methodology for share valuation sets the rules of engagement in advance and helps ensure that all parties to share transactions are satisfied they are getting a fair deal. On the other hand, if shares change hands at off-market prices even once, it colors how buyers and sellers view the prices they should get in all future transactions.
Most buy-sell agreements either specify a formula based on a firm’s financial metrics or require a valuation by a third-party appraiser. What are the pros and cons of a valuation formula versus an appraisal, and which one is right for your firm? We offer the following:
Valuation formulas are far from perfect, but do have some advantages over appraisals:
- Simple. Once developed, formulas can produce a valuation estimate in as little as a few minutes, depending on a firm’s financial reporting system and practices.
- Transparent. Anyone with access to the firm’s financial statements can verify the calculation and see the justification for the result.
- Objective (in application if not specification). While specification of the valuation formula carries a measure of judgment, there is no guesswork or judgment in how the formula is applied once it has been set.
- Affordable. Once developed, valuation formulas are relatively cheap to apply on an ongoing basis.
Despite these advantages, however, valuation formulas also have serious pitfalls:
- Often off-market. Reliance on formulas alone and ignoring other potentially significant factors can lead to an unfair deal for buyers or sellers.
- Static. The fair value of a firm depends not just on the firm’s results but on broader economic conditions. Valuation formulas rarely adjust when those conditions change.
- Fragile. Valuation formula results can be skewed by an aberrant year and fluctuate excessively from one year to the next.
- Backward-looking. Formulas usually consider firms’ past results only, and do not take into account their future prospects.
- Blind to individual circumstances. Formulas are usually based on market averages, which may not be appropriate for the firm due to differences in location, business model, indebtedness, working capital management, and other factors that materially impact value.
- Incorrect in dealing with purchases and sales. Because formulas rarely account appropriately for balance sheet structure, the value of shares can change without justification instantly upon purchase or sale. This creates undeserved windfalls for some shareholders at the expense of others.
In light of these pitfalls, if you do choose a valuation formula, ensure that it appropriately accounts for non-operating assets and liabilities, have it revalidated every few years or whenever economic conditions change, and calibrate it to a forward-looking appraisal.
So all told, when should you use a valuation formula over an appraisal? It makes most sense when stock transactions happen often and in relatively small amounts, when transparency is more important than accuracy, and when the company has a stable strategy and financial results. On the other hand, you should not use a valuation formula when a sizeable transfer of ownership is being contemplated, an accurate valuation is paramount, or an independent, third-party imprimatur is required.
Ownership Transition: Where Will All That Money Come From?
Financing ownership transition can present a formidable challenge. As an owner or transitioning senior partner, you want to realize the value of your investment and limit your risk by getting paid out quickly while at the same time making the process realistic and attractive for new or up-and-coming partners. But not many design professionals – even those in the prime of their careers – have hundreds of thousands or millions of dollars in excess cash just lying around to buy you out. So how can you get the value you’ve built while still making purchases affordable for the next generation?
The number of ways you can structure a transaction is almost infinite, but at a basic level, the money to buy out founders ultimately will come from one of four sources:
- Future cash profits. At their core, most ownership transition financing strategies are about finding ways to divert cash flow from anticipated profits to pay out retiring shareholders.
- External financing/increase net debt. Also called “Other People’s Money,” this option introduces a third-party lender to the equation, with guarantees provided by individuals or the firm itself. No matter who makes the promise, the expectation is any external financing will have to be repaid from the firm’s future profits, so this is really a bridging solution.
- Cashing in the whole life insurance policies that many firms hold on the retiring principals. Depending on the firm, this can make a significant dent in the financing need for orderly ownership transition and make use of an often-overlooked asset on the balance sheet.
- Direct cash purchases by rising shareholders. This is the classic “skin-in-the-game” approach used by some firms for many years. While some ownership groups prefer helping to arrange financing for the new partners from a cultural perspective, others value the commitment demonstrated by shareholders investing their own funds in the firm.
The most common solution is some form of seller financing. Basically, the sellers are paid out over time with a promissory note or deferred compensation, while the company makes a loan to the buyers that they repay in part from their share of the firm’s profits and/or payroll deductions. Sometimes, firms will offer a cash bonus or initial share grant to ease the burden of the initial share payment. That can be justified as a bonus that is given in recognition of the person’s having made sufficient contributions to the firm to earn the opportunity for ownership. Or, a raise can be given in recognition of greater responsibility.
Ultimately, the most impactful thing you can do to ease the financing burden is to plan for your ownership transition at least 5-10 years in advance. While financing ownership transition can be intimidating, there are many ways to crack the financing nut if you start early.
June 10-11, 2020 • Boston, MA
Connect with decision-makers from both national and regional firms that are interested in expanding in the West.
Jan 22-23, 2020 • Miami, FL
THE event for Southeast firm leaders considering a sale or merger and leaders of AE firms looking to grow through acquisition in the Southeast.
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