When You Need to Change Your Valuation Method
Valuation is not a one-size-fits-all process, and a firm’s unique characteristics will dictate the particular approach that is taken. However, there are certain common issues that can create unintended consequences and make a stock-transfer program more challenging. If any of the following common pitfalls apply to you, we recommend changing or tweaking your valuation method:
1. If a valuation is based on book value rather than business value.
Valuation professionals who use the book value method employ an asset-based approach in which they subtract the book value of a firm’s liabilities from the book value of assets as they appear on balance sheets. While the book value method has the advantage of being relatively straightforward and easy to understand, the downside of using it in the AE industry is that true value is based on people, expertise, reputation, and organization, rather than on physical assets, such as vehicles and computers. Income- and market-based approaches, where the value is based on earnings capacity or transactions of similar companies, better tie valuation to its true drivers. The book value approach often significantly undervalues the stock and is typically only appropriate for commodity-related, capital-intensive businesses—such as equipment rental companies or hotels—in which assets are fundamental to income production.
2. If a valuation formula does not consider debt and cash on the balance sheet.
If you have two identical firms—A and B—but Firm A has $1 million more in the bank than Firm B, Firm A is worth $1 million more. On the flip side, if Firm C has $1 million more in debt than otherwise-identical Firm D, Firm C is worth $1 million less. This is not true of all assets and liabilities (which is part of why book value is not a good valuation method), but cash and debt are just two examples of non-operating assets and liabilities that should be adjusted for.
3. If it’s been a while since you had a valuation done.
It’s important to have a checkup done on your firm’s valuation on a regular basis. Since valuations are developed using assumptions based on the facts available at the time of the valuation, those assumptions will shift whenever the underlying facts change. It’s a good idea to invest in a third-party expert to provide an opinion on the continuing validity of your valuation formula and calibrate it to a forward-looking appraisal every few years, whenever conditions in the economy or the AE industry change, and especially when the firm has grown or contracted or is facing a significant transfer of shares from one or more partners to another. It’s possible that the core methodology can be maintained with just a tweaking of the parameters, although a larger overhaul might be required.
4. If a valuation method is open to interpretation.
One of the biggest advantages of a valuation formula is that it’s an objective, transparent method of determining firm value. But if a defined methodology is not used to determine a firm’s value, it could be open to multiple interpretations. The point of a shareholder agreement is to negotiate the divorce settlement while you are still friends. Utilizing a valuation method that sows divisions by creating confusion can sabotage this purpose. If your valuation method is open to interpretation or discretion of company insiders, it’s time for a change.
The value proposition
When Should a Leader Become an Owner?
While AE firms are filled with many talented leaders, not all of them are inclined or ready to take on ownership stakes. It takes years to execute a successful ownership transition plan, and an essential element of that plan is identifying the next generation of owners who will drive the future value of your firm.
Since ownership and leadership are so closely linked in the AE industry, a lack of competent next-generation leaders may make it impossible for firm founders to stage internal ownership transitions and proceed with their desired exit strategies. This is a major reason why so much industry consolidation has taken place in recent years.
As your firm grows, identify those rising stars who are acting like firm leaders by showing an entrepreneurial “firm-first” mindset, making sustainable use of staff and financial capital, delivering great experiences to clients, and generating enough money to pay for today and invest in tomorrow.
When should these individuals become co-owners of your practice, and why is it worth considering sharing those benefits? In a larger firm, it can be worthwhile to develop formal criteria that delineate what it takes to become a partner, but fundamentally, leaders should be shareholders when a significant share of the firm’s value derives from their work or expertise.
There are two primary reasons why that’s the case:
- Self-Interest. Having additional shareholders can help protect the value of the firm. Who do you want to run the firm once you are no longer around? Making that person (or people) a shareholder and having an ownership transition process in place sets the stage for long-term continuity of the business.
- Fairness. Anyone driving value in a significant way should share in the benefits.
Just how big a part of the firm’s value does an employee have to be before you consider them for ownership? That depends on the firm’s philosophy. Some firms prefer to have only a small group of shareholders who run the firm as a tight-knit group. Others prefer to share ownership more broadly over a significant fraction of the staff. In fact, we’ve worked with firms with hundreds of staff and a just a handful of owners, as well as firms with just a few dozen staff and nearly as many owners. Your personal and management philosophy and your firm’s culture will help determine where on this spectrum is right for your firm.
It’s also worth considering making employees shareholders when you have identified them as potential future senior leaders of the firm and ensured they share this ambition. This has become an increasingly difficult task as younger generations have been more willing to move from firm to firm during their careers rather than spend decades with a single company and have placed an increased priority on work-life balance.
In order to be successful, the succession plan for the current ownership needs to align with the interests of potential owners. This requires an open dialogue with prospects in which owners explain the required commitment along with the risks and the rewards. These are people you’re going to make a significant investment in mentoring and developing, and you want to know you can count on them to be around for the long haul. Making a rising leader a shareholder creates a reciprocal commitment that can help lock in a future leader and ensure the long-term viability of the firm.
A guide to help you better understand how AE firms are valued and – perhaps more importantly – what you can do to build value now.Read Newsletter