February 26, 2015

Business valuation of equity interests in closely-held operating businesses uses pricing from the public marketplace as a primary guide. Adjustments to the pricing information from the public markets are sometimes made for the “specific risk” of the subject company and, almost always, for the lack of marketability of the subject interest. A review of the economic literature suggests that for closely-held businesses which are also controlled by one family an additional reduction in value may be warranted due to structural inefficiencies and agency problems.

In business valuation, the guideline companies from which market multiples and discount rates are determined are most often companies whose shares are widely held by individual and institutional investors. There are, however, publicly-traded companies controlled by families. Sometimes this control is manifested by the aggregate percentage ownership of shares held by the family. In other cases, family control is effected through ownership of a super-voting class of common stock. Various empirical studies of the market performance of these publicly-traded companies paint a clear picture that such extreme governance characteristics impairs market value. By extrapolation, it is easy to infer that closely-held businesses with absolute or near absolute control vested in one family creates a market pricing environment that is all the more disadvantageous to the outside shareholder.

The agency problem suggested by a family-controlled company can actually have many different forms and combinations. In its simplest form there is the company which is run and controlled by one individual (the “Founder/CEO”). In the prototypical example, he has built the company up from scratch and, through his vision, strong leadership and determination, has built a growing and profitable business. Research suggests that outside shareholders in a company with these characteristics will enjoy above average returns even though the company is controlled by one person. As time passes, things can change which alter the value equation.

Whether or not a succession plan is in place can make a difference in value. For a company with a Founder/CEO approaching retirement age, the market begins to fear the loss of his services. Having a highly qualified successor in place seems to reduce these concerns but not totally. Having a family member as a successor significantly increases the perceived market risk and impairs value.

At some point, as the number of non-family shareholders and non-employee family shareholders proliferates, the company may create a class of super-voting shares to be held by only the Founder/CEO and perhaps a few other family members. This creates a situation which also been the subject of academic study. That is, the effect on value when there is a disconnect between percentage voting power and the percentage of ownership rights to the company’s cash flow.

For valuation purposes, we are usually assuming a hypothetical third party buyer of a minority interest in common stock. The buyer would be purchasing the shares solely based on the potentiality for an economic return from owning the shares. Accordingly, the non-employee shareholder wants to see earnings and cash flow as high as possible and bonuses as low as reasonably possible. There is no question that, given the nature of the Company’s business and ownership structure, that a non-employee shareholder’s preferences would not be a priority of the board of directors.

Villalonga and Amit find evidence linking market valuation to family dynamics. Their research shows that, on average, family-owned firms do well when run by the founder but do not do well when the founder is succeeded by a family member. The statistics indicate that when the CEO is succeeded by an outsider-CEO, the Company’s performance does decline but not nearly as much as when the CEO role is assumed by a family member.1

To this point, Perez-Gonzalez states: “Family successions are likely to be anticipated. Therefore the bulk of my empirical analysis focuses on changes in firm performance around CEO successions, measured as changes in profitability on assets and market to-book ratios. The findings of this paper are broadly consistent with the idea that a significant number of publicly traded “family firms” promote CEOs based on family ties rather than on merit. In these data, 85 out of 192 successions yield a family successor. Family CEOs are promoted to the post an average of eight years younger compared to unrelated executives. Empirically, I find that family successions harm firm performance: return on assets falls by 18 percent and market-to book ratios by 12 percent within three-years of the transition, relative to firms that promote unrelated CEOs.”2

This would place a non-employee shareholder squarely in the middle of the kind of “agency problem” discussed by economists Michael Jensen and William Meckling in “Theory of the firm: Managerial Behaviour, Agency Costs and Ownership Structure.” 3

1 Villalonga, Belen and Amit, Raphael H., How Do Family Ownership, Control, and Management Affect Firm Value? (December 10, 2004). AFA 2005 Philadelphia Meetings; EFA 2004 Maastricht Meetings Paper No. 3620; Fifteenth Annual Utah Winter Finance Conference. Available at SSRN: http://ssrn.com/abstract=556032

2 Perez-Gonzalez, Francisco, Inherited Control and Firm Performance (July 2002). Available at SSRN: http://ssrn.com/abstract=320888 or doi:10.2139/ssrn.320888

3 Jensen, Michael C. and Meckling, William H., Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure (July 1, 1976). Michael C. Jensen, A THEORY OF THE FIRM: GOVERNANCE, RESIDUAL CLAIMS AND ORGANIZATIONAL FORMS, Harvard University Press, December 2000; Journal of Financial Economics (JFE), Vol. 3, No. 4, 1976. Available at SSRN: http://ssrn.com/abstract=94043 or http://dx.doi.org/10.2139/ssrn.94043