As I am flying over the clouds heading for London, I can never quite avoid getting emotional. The peace and tranquility of the clouds get me every time.
We get emotional about many things all the time. Sometimes it helps, sometimes it doesn’t.
But can we get emotional about family business? Is a family business not just a means to an end?
Another paper crossed my desk a couple of weeks ago that started these questions. The paper (Astrachan Joseph & Jaskiewicz Peter, 2008) describes how a family business is also an emotional affair for the principal. Now, I do agree that this is not something that will make the news, and entrepreneurs around the world will recognize this as “their baby”. Again, this attachment to “the baby” can play out positively or negatively. In the end, it’s all about awareness: are we being cognisant of which emotion is playing when we take a decision?
How are Family Businesses valued?
One of the golden oldies of Family Business valuations is what Swiss accountants call the “Praktikermethode”, the practitioner’s method. This method takes, usually, one part substance value and two parts income value and divides it by three. The substance value is the capital in the company, the income value derives from the net profits which are present-valued.
One step up in sophistication is models like CAPM, etc. to (somewhat) accurately assess the value of an asset. Ultimately, many variables have a massive impact on the final valuation, and these variables are (somewhat) arbitrarily set. One source of contention is the application of beta: what is the proper value to apply? This is especially true if the family business cannot be easily compared to a competitor, due to some unique factor or due to the lack of data available.
As this blog is not about the CAPM or the “Praktikermethode”, I will not go into these calculations any further.
What is Emotional Value and why is it missing in Family Business valuations?
The one value that is missing, argues the above-mentioned paper, is the Emotional Value.
Most business owners will recognize this non-financial value as the company is more than an asset generating a return for profit maximization.
One Emotional Value comes from the family’s utility generated from the family business: this can come in the form of some intrinsic business value (creating products in alignment with personal taste or quality expectations), a family value (employing family members), or personal value (pride, or standing within the community, for instance).
Formally, the Emotional Value has its mathematical notation, being:
Total Value = Financial Value of the Firm + Discounted Financial Private Benefits + (Emotional Value – Emotional Costs)
Whilst we can instinctively feel the Emotional Value, we should also be aware of Emotional Costs.
Emotional Costs are negatives attached to the family business. Examples are:
- Minority interests and agency costs – minority shareholders in a family business may be part of the company, but how much are they able to help steer the company, and to what extent are they reliant on the goodwill and performance of another majority (family) shareholders? This brings again the issue of agency costs A family member who is managing a family business may have other objectives than the shareholders. What systems and measures are put in place to avoid a family member becoming a rogue agent? It’s not always that maleficent: sometimes these issues arise from well-meant differences of opinion based on the different viewpoints each party has. How are such issues mitigated and resolved?
- Other factors that can lead to rifts within the family are jealousy and rivalry within branches of a family. One family member is chosen to lead the family business in the future. What about the other family members? An external advisor can help in such cases to mitigate such rifts and provide a fruitful ground for the succession to take place (whilst at the same time shielding the successor from unwarranted attacks).
- Emotional Value is not stagnant; it changes in value over time. As each family member becomes older and has their own set of experiences, their Emotional Value will change. Emotional Costs can – in this case – turn into Emotional Value, which makes a divestment decision not easy to take.
How do identify Emotional Value?
- Several factors can be identified that point to the existence of an Emotional Value. These are:
- Investment decisions are being done contrary to what IRR/NPV would dictate. Additionally, personnel decisions might not follow normal procedures;
- Diversification decisions benefit the family more than the family business. This is an interesting one for me: in many cases, the family business represents a majority of a family’s assets. The family has a relatively low level of diversification. One way to diversify is to do a “look-through” and have the family business invest in bankable assets, although this may not be needed from a company’s capital requirements (i.e., it would be more efficient to distribute the profits/capital out to the shareholders). This is not done due to tax reasons and thus, the family’s wealth is deferred in the family business. Looking from the outside, the family’s wealth is not diversified. With the “look-through”, the diversification becomes more apparent (albeit it is “stuck” in the family business and may only be retrieved at a later point in time);
- Investments with high reputational benefit for family members;
- Reluctance to divest a family business. This points to the forward/backward-looking aspect of our model (LINK). Sometimes a legacy can become oppressive for future generations.
- Focus on the historical drivers of the family business (geographical location of business, customers, or customer segments)
How your Family Values and the Emotional Value of your Family Business fit together
Often, there is a clear alignment between the Family Business’s values and the family’s values. The Emotional Value will therefore extend also to the ability to focus more strongly on a value-driven leadership style than in a public company. The Family Business will therefore become a conduit for the family’s values – as such providing an Emotional Value to the family. If family members prescribe these values, then they should receive a similar amount of Emotional Value from the Family Business. Unfortunately, there is also a caveat: in large families, the values can differ between the branches – hence the Family Business values might not correspond to all of the family branches’ values, creating no Emotional Value (or even Emotional Cost) for some family members (another example of the “unintended benign agency costs”).
The level of influence will be larger for a family with a controlling stake in a Family Business. In contrast, public companies do not necessarily allow families to establish an Emotional Value as such, besides the little alignment that is possible between family values and the ESG framework provided. As imperfect as it is, it is at least a step in the right direction.
The concept of Emotional Value can be a good starting point for discussion within the family – especially when there are different viewpoints on what direction the family business and the involvement of family members should be. A high Emotional Value might be the basis for an explanation of one’s action. Similarly, a low/negative Emotional Value might be a starting point to discuss how the balance of legacy and practicability should be achieved. In some cases, a divestment might be the best way forward. But how is the legacy then achieved? An alternative would be to donate parts of the proceeds to a philanthropic purpose or build a museum, etc. to commemorate the achievements of the family’s past generations.
Another interesting aspect – especially when considering a divestment is that you are not a seller, but – to paraphrase Dan Sullivan – a buyer: you exchange the family business with proceeds you will use another way. In that sense, you are “buying” other assets. Are these of at least the same value to you as what you have sold your family business for?