Whether a business valuation is done for purposes of transferring ownership internally from one employee to another, or for meeting the regulatory requirements of sponsoring an employee stock ownership plan, the risk associated with such an investment is a critical element in determining its value.
So, what is risk? Oftentimes, an appraiser will look at risk from a business operating point of view. When valuing a closely held firm operating in the A/E industry, we look for risk in areas such as key personnel, customer concentrations, markets served, and geographic concentrations – just to name a few. Aside from these, another area of risk to which we’ve been paying much closer attention lately is stock redemption obligation risk. This risk is often accounted for in the discount for lack of marketability.
If your firm receives an annual valuation of its common shares from an accredited business appraiser, then you will be familiar with the discount for lack of marketability. This is the discount rate that is applied to the underlying security being valued to account for its illiquidity. In a closely held company, the transfer of shares is often restricted by the terms of a shareholders’ agreement. Often, shareholders in such firms may only sell their stock under certain circumstances and only to certain buyers– typically other employees and/ or the company. The discount that is applied to account for this illiquidity is determined by many factors, but the most common factors that are considered include; company characteristics such as size, performance, and operating risk; restrictive transfer provisions; dividend payments; rights to sell shares back to the company (“put rights”); information access and reliability; and attractiveness of the industry or company to investors. But because of recent trends in the industry, these factors alone may no longer fully account for illiquidity.
Since the recession, many A/E and environmental consulting firms have postponed their ownership transition plans because their values have fallen, and retiring shareholders have been unwilling to sell at a depressed value. The resulting delay in transitioning ownership has increased the shareholder repurchase obligation risk at many firms because there are more people closer to retirement today than there were in 2008. Most shareholder agreements stipulate that either the company or its remaining shareholders will repurchase the shares of retiring shareholders. Either way, the company must make available adequate cash flow to fund these obligations. Competing for this cash flow is the need to reinvest in working capital and fixed assets as the firm grows. The potential strain on cash flow has the potential to impair the liquidity of the company’s stock, and must be carefully examined by the appraiser and management alike.
Below are the key forces that compete for a firm’s cash flow, and therefore impact its value:
Over the past two years, we have seen more firms shift their cash flow allocation to improving shareholder liquidity, but this has come at the expense of allocating cash flow to incentive compensation. The valuation of your company must consider not only the liquidity risk of the shares, but the risk of not being able to invest in growth because of increasing cash flow demand for shareholder repurchase obligations. Reviewing your shareholder and employee demographics should be considered when understanding the risk of owning stock in your company.
If you are interested in learning more, we will be conducting a one-day seminar on ownership transition strategies at the San Diego Bayfront Hilton on Thursday, May 15th. Come join Steve Gido and me as we present options that address your ownership transition challenges while managing your valuation risk.