Family-owned businesses are an essential component of many national economies; German small and medium-sized enterprises (SMEs), in particular, enjoy an excellent reputation worldwide. Many of these companies are family-owned and/or family-run. This is often accompanied by a long corporate tradition and management and ownership structures that have evolved over generations. Succession planning is of immense importance, particularly for family-owned businesses, because the traditional principle that children join the family business is no longer the only option; as a result, external succession is becoming increasingly important for medium-sized family-owned businesses. An important factor in business succession is determining the fair market value of the company. The differences in business valuation between internal and external succession are explained below.
The Importance of Business Valuation for Family-Owned Businesses
For every company and its shareholders, knowing the company’s value is of essential importance. In family-owned businesses—unlike in capital-market-oriented companies—it is not solely financial factors and the maximization of “shareholder value” that matter. Factors such as financial retirement planning for one’s own or future generations, the company’s reputation and brand name, as well as social considerations, often play a greater role. Companies that have been family-owned for generations also often have highly complex ownership structures that have evolved through intergenerational gifts and inheritances. This can lead to both harmony and discord among family branches, which in turn can influence the company’s operational performance.
The Distinction Between Internal and External Succession in Family Businesses
In the case of internal succession planning, the business is transferred within the family (often to the next generation). The challenges involved in business valuation for internal succession are manifold. On the one hand, maximizing the value of the business is not the primary focus, and at the same time, internal family disputes must be avoided. At the same time, the succeeding family members must possess the appropriate qualifications for entrepreneurship. Tax law requirements must always be taken into account, and tax planning opportunities must be utilized to minimize the financial burden on the succeeding generation.
In the case of external succession planning, an external investor acquires the company. In this scenario, while business valuation and maximizing the sale proceeds are not the sole focus, they remain a key consideration for the selling party.
Is the Valuation Method the Same for Internal and External Succession?
Succession planning for family-owned businesses is one of the reasons for conducting a thorough business valuation. In the case of external succession, the primary goal of the valuation is to ensure market feasibility and to achieve a “market-based” price. In the case of external succession, the price is determined by the interplay of supply and demand in the market. Investors often rely on so-called multiples to indicate a market-based valuation. However, a sale price can be maximized, for example, through a successfully structured bidding process involving multiple investors.
In the case of internal succession, on the other hand, the primary objective is not to achieve a maximum sales price, but rather to determine a company value that complies with the tax requirements of the tax authorities and meets the provisions of the Inheritance and Gift Tax Act. To this end, the “Principles for Conducting Business Valuations,” known as IDW S1, which are recognized in practice and by the courts, have become established in Germany. The financially sound, mathematically grounded valuation in accordance with IDW S1 is conducted from an investor’s perspective and takes into account the company-specific opportunities and risks by using a multi-year financial projection.
In general, the reason for the valuation is of essential importance when conducting a business valuation and should be communicated at an early stage in order to identify the appropriate valuation methodology. When planning succession for family-owned businesses, it is important to distinguish whether the succession is intended to be internal or external. As part of an IDW S1 valuation report, the individual enterprise value is then determined based on company-specific factors and a multi-year financial projection. Such a report—prepared by a qualified expert—is recognized by both courts and regulatory authorities and simultaneously provides a transparent basis for negotiations in any transaction.
