How the value of a business is eroded

V Ranganathan | Updated on January 09, 2020 Published on January 09, 2020

Influencing factor Management quality has played a role in the valuation of the business   -  Rawpixel

The generation divide and differences of opinion in a family-owned company may erode intrinsic worth

There is a fundamental economic difference between ‘price’ and ‘value’. Just like commodities and goods, command a price based on their value, businesses also have a price based on its value. Values of a business are built over time, brick by brick. They can also be destroyed overnight by one misadventure or by mismanagement.

Of late, there is a conspicuous erosion in the value of business due to several reasons. It is easy to blame the market and environment for value destruction, but one must be honest in acknowledging that in several cases, the values of business are destroyed due to internal rifts, inept management and faulty succession planning. The million-dollar question is how to fix accountability for value destruction. The tendency is always to pass the buck when the going is bad, and hence nobody is held accountable.

Succession issues

Business valuations is both an art and a science. Art, because it produces a set of numbers that defy common sense and logic, but at the same time satisfies the seller and the buyer. And science because there are different scientific methods that are used to arrive at an appropriate business valuation. Most of the transactions that use valuations rely on the future prospects of the business, as well as heavily on the future of India’s growth story. When the going is good, valuations reach dizzying heights and have no correlation to the past and present business performance.

Interestingly, there have been cases when valuations are at a premium largely on the basis of the management quality, not just the business model. In other words, the premium is more for the ‘person behind the business’, rather than the business itself. Family-owned businesses struggle to maintain and grow the valuations, more so when succession of the business becomes an issue. Passing on the baton to the next generation is normal but, at the same time, challenging. If the incumbent delivers results, it is viewed as a success. If he fails, then there is an outcry: “The baton should have gone to a professional rather than a family member”.

While blood is always thicker than water, the current thinking and trend is to professionalise the management to maintain and enhance the value of business. Sometimes, succession to the gen-next family member happens in form, but not in substance. The father, or head family member, defying all challenges of age attends office wearing some tag or the other — breathing down the successor’s neck, so to speak. The crux of the problem is that the father in question has no alternative interests or activities except, as a matter of routine, attending office. There is virtually no room for the successor to grow. How will he/she succeed if there is no independence?

When to make an exit

Company promoters having tasted success over generations have to deal with the most uncomfortable question: do they exit and encash value or maintain status-quo, knowing fully well that value is being destroyed. This is not an easy situation to handle. Several issues have to be dealt with, notably: the next generation is not interested in the business; the passion is alive, but old age beckons; what comes after the exit; the company perks, status and position may all go away.

These are only illustrative and not exhaustive questions that stare at the promoter’s face. Smart entrepreneurs have entered the business at the right time, but also have exited at the right time. In the case of serial entrepreneurs and first-generation businesses, the decision-making process is simple and straightforward, bereft of emotion.

Complications arise in the case of family businesses with shareholders and directors pulling the company in different directions. The attachment to positions and perquisites weigh heavily in the process of decision-making here. Office-maintained swanky cars and business-class foreign tours are not easy to give up. Holding on to these incentives become more important than welfare of the business itself.

Professional clashes

More often than not, differences among shareholders arise on account of ego clashes and bids to prove who is better. All such clashes lead to destruction in the value of business. The issue gets more complicated when the value systems between one group and the other differ drastically. It has a direct bearing on the performance of the business and the ability to nurture and retain professional managers.

It is in these situations that a board comprising both family representatives and independent directors should work together to preserve and enhance the value ethos of the business. From the examples available in the public domain, it is clear that independent directors have had to side with one group or the other. The cases in point are Indigo, the Tata group and Ranbaxy.

As the saying goes: collective wisdom is given a go-by to achieve short-term goal of usurping or retaining power at any cost. Minority shareholders are, in these situations, mute spectators at best.

The issues raised above are well-known and quite commonly encountered. However, the solutions do not come easy. The reason for this is the lack of cohesive thinking across generations, and the older generation being more comfortable with status quo. The younger generation has ideas and passion which may dictate its thinking quite differently from its predecessors.

One approach which may have worked in a few cases would be the introduction of a financial or strategic investor into the business, to help improve the management bandwidth, bring in professionals and pave the way for a seamless transition of the business from being family-managed and -owned to partially owned by the family, with professional investors and managers to march the company into the future.

Finally, one has to do away with selfish intent to enjoy the benefits of office and look at the larger picture of preserving and enhancing value.

The writer is a chartered accountant

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Published on January 09, 2020
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