Many small manufacturing businesses are run by families. Unfortunately, when business and personal lives are so intertwined, disagreements can happen and family members may decide to part ways. There are a few valuation methods that apply when buying out a dissenting shareholder or dividing up a marital estate that includes a family-owned business.

Valuing a Private Business Interest

During shareholder divorces and buyouts, it is important to determine how much the business is worth. There are three ways to value a privately-held manufacturing business:

  • Cost Approach

The cost (or asset-based) approach starts with the company's balance sheet. Adjustments are then made to various balance sheet accounts, such as inventory or equipment, in order to reflect the fair market value. For example, raw materials inventory may be undervalued if your company uses the LIFO (last in, first out) method. Similarly, equipment may also be undervalued because manufacturers typically use accelerated tax depreciation methods. The cost approach may also overlook goodwill and other intangible assets. The value of intangible assets is better captured by the market and income approaches.

  • Market Approach

This approach derives value from the sales of similar businesses. Here, the value of the company is derived from a pricing multiple, such as price-to-earnings or price-to-EBITDA (earnings before interest, taxes, depreciation and amortization expense).

  • Income Approach

Under the income approach, a future earnings stream (typically cash flow) is discounted to its present value. Stable cash flow is then divided by a capitalization rate, which can be thought of as the mathematical inverse of a pricing multiple under the market approach.

Measuring Goodwill

Goodwill is the excess of a business's value (under the income or market approach) over its net tangible book value (the cost approach). In a few states, the entire value of the business is part of the marital estate. Alternatively, some states exclude all goodwill from the marital estate.

About half the states distinguish goodwill as either personal or entity. The former cannot be separated from the business owner, whereas the latter is a function of the business's location, employees, name recognition, contracts and customer lists. These states include entity goodwill in the marital estate, but exclude personal goodwill if maintenance awards are based on the owner's future earnings.

Personal goodwill is most frequently associated with professional practices, such as medical practices or law firms. However, some courts recognize that manufacturers can also possess this type of goodwill. For example, business success that is tied to key relationships with the owner or if the owner has unique knowledge that cannot be transferred to others would be considered personal goodwill.

When evaluating personal goodwill in a dissenting shareholder context, it is important to consider whether personal goodwill could be transferred to a third party. If a shareholder would need to work closely with a hypothetical buyer to transition the business after a closed deal, a portion of personal goodwill might belong to the individual shareholder, rather than the business.

Adjusting the Financials

Family businesses are not always run like major companies that strive to maximize profits and shareholder value. Therefore, adjustments may be needed to reflect how unrelated parties would operate the business.

Common financial statement adjustments include:

  • Owner and family compensation and perks (company vehicles and season tickets to sporting events, etc.);
  • Non-market value rent paid to related parties;
  • Inventory accounting anomalies; and
  • Unrecorded liabilities (pending lawsuits and warranty claims).

When valuing a minority owner's interest, courts in divorce and dissenting shareholder lawsuits generally consider whether a buyout price is fair. So, they may sometimes be reluctant to apply discounts for the lack of marketability and control if the discounts would provide a windfall to the controlling shareholder.

Finding Your Expert

These valuations are likely to face scrutiny in court. If your business needs to be valued for a shareholder divorce or buyout, contact a business valuation specialist. Choose someone who understands manufacturing industry trends, accounting practices and key value drivers.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.