Executive Corner: Does the Valuation of Your Company’s Stock Reflect ALL its Risk?
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
An appraiser often looks 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.
Discount for Lack of Marketability?
Another area of risk we’ve been paying closer attention to lately is stock-redemption obligation risk, which often is accounted for in the discount for lack of marketability. This is the rate that’s applied to the underlying security being valued to account for its illiquidity.
In a closely held company, the transfer of shares often is restricted by the shareholders’ agreement, and they may only sell stock under certain circumstances and to certain buyers (typically other employees and/or the company), and the discount to account for this illiquidity is determined by many factors.
Since the recession, many A/E and environmental consulting firms have postponed 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 appraiser and management alike.
Competing for Cash Flow
The following are key forces that compete for a firm’s cash flow and therefore impact its value:
• Working Capital—The largest working-capital requirement of a firm in the A/E industry often is accounts receivable. The slower you collect, the more cash you’re required to invest in your company.
• Capital Investment—New equipment, tools, office expansion, and training and development for new employees requires cash. Will your firm be able to adequately train and equip new employees to deliver the services your customers demand?
• Redemption Obligations—On average, 10,000 people a day reach retirement age (65), and there’s a much smaller group of younger employees available to purchase the shares of retiring employees. To manage their cash flow, many A/E firms will issue promissory notes to ensure they have adequate cash flow to fund this obligation. This approach increases financial leverage risk, however, and firms should be cautious not to take on too much debt.
• Incentive Compensation—For many firms, incentive compensation hasn’t returned to its former levels. In fact, there are still many firms that have yet to reinstate their 401(k) matching programs. Will your firm have adequate cash flow to keep its talented employees?
• Return on Investment—A key factor in creating demand for ownership in a closely held company is the annual profit distribution to shareholders. Typically, shareholders are paid “last” (i.e., after employees, vendors, debt holders, etc.), but they have the highest reward potential. If your firm is unable to make meaningful profit distributions to shareholders, this could have a significant impact on share liquidity, as many buyers depend on the return to help fund the cost of their investment.
Recently, we’ve seen more firms shift cash-flow allocation to improve 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.