Valuing a Business: 5 Mistakes Owners Make
02 May 2022: Valuing a Business: 5 Mistakes Owners Make
Valuing a business, as anyone who’s been following the blog should know, is one of the first – and certainly most important – steps in the process of selling a business. I mean, if you don’t know what the thing is worth, how can you establish a price that can be both realistic enough to facilitate a sale and completely justifiable to reduce disagreements?
But as most of you probably know by now, must business owners have an exaggerated opinion of the value of their business.
This is a problem we’ve run into for years and we tried to come up with a series of bullet points that is part of one of our early meetings with business owners that are considering selling. Here are the top five mistakes we see owners make when they try to come up with a value for their business.
1) Unrealistic Expectations and Assumptions
As I mention above and in many past posts, it’s quite common for business owners to have a exaggerated opinion of the value of their business.
This can be the result of what the business has provided the owner over the years; nice home, late model cars, university education for three kids, vacation house at the beach and countless other benefits that flow from business ownership. It might also come from the owner’s assumption – possibly erroneous assumption – of the future growth of earnings or cash flow.
It can even be the result from some idea that the owner has – but has not implemented – that the owner believes will supercharge the business’ growth. And it can also stem from the owner’s ignorance of how businesses are valued.
For example, if the owner believes that he or she has an idea that, once implemented, will increase sales by 30%, it would indeed increase the value of the business – but only of the owner implemented the idea before selling. If the buyer has to implement the idea, there is little justification for the owner to get paid for the work the buyer will have to do.
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It’s tough for some business owners to understand that. And though they are extremely knowledgeable about the workings of their own business, they are quite unlikely to be as knowledgeable about most other things in life – including how to value and sell that business.
2) Doing Their Own Valuation
Valuing a business is a complex process that takes training and experience. Few owners have either.
This process contains numerous pitfalls that an inexperienced owner – or improperly-trained broker – is likely to encounter even without realizing it. For example:
- Failing to “normalize” earnings, a process we refer to as “recasting” those earnings.
- Failing to establish the business’ real earnings; the “owner benefits”.
- Applying a multiple to those earnings that is unsupported by market demand
- Using projections of future earnings that can’t be supported
- Valuing assets based on cost or balance sheet value instead of fair market value.
Valuing a business requires not only using the correct numbers but understanding what the market for the business’ products or services is likely to look like in the future – and to a buyer. When selling, business owners generally not only see nothing but sunny days, they’re generally wearing rose-colored glasses when they’re looking
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3) Expecting or Establishing a Fixed Number
The cover letter that accompanies any valuation done by us contains the following phrase:
Determination of the MPSP (Most Probable Selling Price) is not a science but rather relies on the body of work done over the years by Worldwide Business Brokers and others, the business knowledge of the Broker overseeing the process and the use of proven tools and methodologies to yield a reasonable level of accuracy but with no assurances.
We encourage everyone who enrolls in any of our courses to use the same or similar language.
Why? Because valuing a business is as much art as science.
When a business is properly valued, the result any valuator or professional business broker will present is a range of values – and data to support their conclusions. One of the primary reasons for this is that selling a business is usually at least a six to 12-month affair – and a lot can happen in the world in that period of time. And for proof of that statement, just look at what has happened in the last month with interest rates – and what is projected to happen for the rest of the year.
When valuing a business, we always explain to the owner that we’re providing an “estimate of value” and that, should a sale happen, the ultimate selling price will reflect the level of motivation to get a deal done on the part of both the buyer and the seller.
4) Ignoring the Competition
Business owners rarely consider that there are, at any point in time, thousands of businesses looking for buyers. Those businesses are all competing to be “the one” for one of those buyers and their money. When we’re discussing the possibility of selling someone’s business, we are at pains to point this out to them. In more than 20 years advising owners and selling businesses, we’ve rarely encountered an owner that has given this the first thought.
The businesses we bring to market have to be priced competitively or buyers will simply pass us by and go on to the next opportunity.
Some business owners think that their business is unique. Unless this owner invented a perpetual motion machine, this is rarely the case.
No matter what they think, theirs isn’t the first widget manufacturer or specialty restaurant or web developer or social media marketing company that has been sold. Sure, their widgets might be stainless steel; they may have a special sauce for their burgers; their website may offer faster load speeds; or their marketing algorithms may generate slightly tighter results. But in the end, they are delivering a product or service that dozens – or hundreds – of business that have previously sold have delivered.
5) Not Considering the Buyer’s Needs
Few buyers buy because they think owning a business is “cool”. (See “The Buyer’s Perspective“)
Financial buyers, once they find a business that interests them from a professional and emotional standpoint, will ask some version of the question, “How much will this business put in my pocket?” Their next question will be, “How much am I willing to pay for that?”
Put aside for a moment the competition issue and consider what the buyer needs.
Aside from the basics, the buyer needs a return on his or her investment. They will, after all, be raiding the family retirement plan or emptying the savings account where they’ve been earning money on their capital. They need to continue to earn money on that capital whether it’s invested in an S&P 500 ETF or the owner’s business. And given that owning a small business is a significantly greater risk that the S&P 500, the return on the buyer’s investment should be much higher so as to reflect that additional risk.
The Bottom Line
A business owner considering selling their business must understand that a successful sale starts with knowing what the business’ value is.
Knowing the value prevents several unpleasant things from happening:
- Leaving money on the table when the business is sold at a discount to value – a distinct possibility of you have no idea what the value is.
- Spending years trying but never selling because the price asked is too high.
- Being unable to justify the asking price to a buyer.
- Being offended by seemingly “low-ball” offers that actually reflect the true value.
Even if you want to try to sell the business yourself – a move tantamount to a surgeon trying to replace his own liver – get a professional to value it. You’ll at least know where you stand and what you can expect when you start the selling process.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
This week one of the inquiries we received was from a U.S.-based company looking to acquire multiple SaaS (software as a service) companies with between $1M and $5M in revenue. They’ve just completed their fourth acquisition and are looking for more.
If any of you know of something that might fit, please let me know.
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 1,000 in the world. He can be reached at joe@WorldwideBusinessBlog.com