Importance of Valuation in Ownership Transition Planning

Matt Godwin and David Edwards

The built environment features many examples of successful multi-generational, family and employee-owned businesses. The generational success of these firms is no accident – they are the result of intentional, strategic ownership planning.

Given that typical transitions take 7-10 years, managing risk is fundamental throughout the ownership transition planning process. To address risk mitigation, business owners need to have a firm understanding of the critical aspects to address in any transition. These include, but are not limited to valuation, taxation, appropriate stock structures (methods to transact stock), estate planning, leadership, and governance. These are the foundation of any ownership transition plan.

As an initial step to understanding the risk spectrum, this article is focused on outlining key valuation considerations and parameters for your review.

Valuation: A Key Foundation

Valuation plays a pivotal role in ownership transition and estate planning, directly influencing timing and potential owner investment and liquidity. Determining the right valuation method hinges on the primary objective—be it a founder’s exit, family transition, or multi-generational continuity. Each has specific considerations and relevancy to address.

For built environment firms planning for an ownership transition or estate or contingency planning, understanding how valuation applies to your firm is critical to ensure a successful transition. The following outlines key valuation considerations for fair market value (FMV), estate planning and internal transitions.

Valuation Approaches

Valuation professionals use three primary methods to evaluate FMV:

Earnings Approach: Uses a capitalization of earnings (multiple approach) alongside a discounted cash flow analysis.
Market Approach: Utilizes a multiple of earnings from comparable public companies and relevant mergers and acquisitions (M&A) transactions.
Asset Approach: Considers the equity (book) value on the balance sheet and adjusted market value of assets (i.e., FMV of fixed assets).

Considerations:

1) Discounted cash flow analysis is heavily dependent on future earnings which is difficult to project for construction firms.

2) Comparable public companies have little to no bearing on the majority of industry firms.

That said, when considering FMV, M&A multiples alongside asset or net asset value often provide more realistic benchmarks. Each segment of the built environment has unique valuation aspects; however, the reality is that FMV is only useful if a company is sold to a third-party buyer.

Estate Planning

A formal, IRS compliant FMV analysis is typically required for estate planning purposes. This utilizes the approach noted above; however, it will typically apply discounts for both minority interest and lack of marketability to determine the transaction value, typically ranging from 20-40%.These discounts depend on the size and nature of the ownership interest being transferred.

The Valuation Spectrum

From a conceptual standpoint, FMI often considers valuation on a spectrum:

Higher Value: FMV for competitive third-party sales or ESOP transactions.
Middle Value: For traditional internal ownership transitions, a more nuanced valuation is required as there are several aspects to consider: 1) financial capacity of the underlying business, 2) objectives of buying and selling shareholders (especially as it relates to the affordability to buying shareholders), 3) the type of construction business, and 4) the buyout methodology utilized.
Lower Value: Often applied in liquidation scenarios, where valuation levels are typically a percentage of the equity value of a business.

For many built environment firms, the reality is that the primary benefit of ownership is not tied to building long-term stock value to be paid out at retirement, but rather, is derived from the ongoing profitability and distributions. Conservative valuations facilitate the ability to shift the benefits of ownership to the buying party and provide the sellers with control and flexibility to achieve their objectives through the transition process.

This creates a foundational valuation framework while supporting affordability and generational transitions while enabling long-term value creation.

Valuation Risks

Risk 1 – Lack of Valuation Methodology. Misalignment, confusion, and risk can arise without a clear valuation framework, especially if a partner departs the business. Even if your firm has one owner, establishing an appropriate valuation can assist in estate planning and dealing with potential IRS issues.
Risk 2 – Outdated or High Valuations. In circumstances in which a valuation is too high or not representative of business reality, it can strain affordability for the company or new shareholder, result in a prolonged timeline and fail to meet a seller’s objectives.

Recommendations

Valuation is a foundational element in ownership transition planning, especially in the built environment, where long-term stability and continuity are often the primary objectives of transition. Whether the transition involves key leaders, employees, family or external buyers, a relevant valuation approach is essential to meet the objectives of all parties involved.

Tailoring valuation to meet stakeholder objectives—whether for ESOPs, internal transitions, or estate planning—ensures a balanced, realistic approach. Further, it is imperative to establish valuation parameters in a Shareholder or Buy/Sell Agreement so that all stakeholders are on the same page.

Our team can help evaluate your current valuation framework to ensure alignment with your company’s transition objectives. This can further your firm for continuity and long-term success.