Valuing a Business on its “Potential”

Valuing a business based on its “potential” is an issue that comes up all the time when we’re working with owners of businesses in both the Main Street and lower Middle Markets.

In most instances, we have to educate the owner that expecting to get paid for how the business might perform in the future is an unrealistic expectation. But not always.

A business’s “potential” comes in several flavors among which are the following:

1. What the seller thinks is possible by making some changes to the business
2. What the seller thinks is possible due to changes in the market
3. What the seller has done that will cause the business to increase in value – without much effort from the buyer.

Figuring out whether any of the things the seller is telling us are or will be the result of his or her efforts, the good fortune of being in the right place at the right time or simply a fit of fantasy on the part of the seller is an important part of determining whether any of the projected “potential” might actually be real.

When we meet with the owners of small business, it’s fairly common for us to hear, “Well, if the buyer just did this or that, he could double sales!”

While that may be true, the key phrase in that sentence is “…if the buyer did this…” We ask the uncomfortable question: “Why would the buyer pay you for the additional value that HE built?” This always results in an awkward pause in the conversation – because there is no possible answer to that question.

If the business gains value as a result of what the buyer has to do, there is no reasonable justification for the seller to get paid for that additional value. Under no circumstances will we take a listing assignment if the owner cannot or will not grasp this simple fact.

Valuing a Business Based on Changes in the Market

Sometimes a seller will tell us that something is about to happen in either the business’s geographic market or industry channel.

For example, the seller of a medical supply business might say that a new hospital has been proposed for a 15 acre site less than a mile from his business. He believes that, once the hospital is completed, his business will benefit significantly and he wants us to factor this into the valuation.

While his conclusion may or may not be true, until the hospital is approved to be built and under construction, the question of the hospital’s very existence is in doubt. Getting approval to construct – and then actually build – a new hospital is a years-long project. In cases like this, we advise our clients that no added value can be considered because there is no solid evidence that a hospital will be built. If they want to get any value from the opening of a new hospital, they have to hold off selling until there is concrete being poured and steel being lifted into place.

But even if the hospital is under construction, there’s no telling what the impact on the seller’s business will be because we can’t consider only that the business’s revenue will go up.

What might happen to seller’s lease? I would expect that a new hospital will cause a reasonable landlord to increase the rent. Other costs may go up. The net result may be no more than a modest benefit to the business.

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On the other hand, here’s an example from our Course, “Learn How to Value and Successfully Sell Businesses“.

If our client owns a convenience store and the 30-acre parcel across the road has just been approved for the development of a 400-unit apartment complex, it would be unreasonable to think that our client’s business will not be positively impacted and we would value that business  using some assumptions about that impact. A buyer might quibble with an assumption or two but it will be virtually impossible to argue with projections that assume increased revenue.

Both of these examples are of “market-changing” events. One will certainly change the value of the business almost immediately and probably in a big way. The other may impact the value of the business but it is very difficult to project how much or when.

What the Seller Has Done

Valuing a business based on the potential of the result of something the seller has already done is another animal altogether.

If the seller has caused something to happen and the buyer will have to do little or nothing to benefit from what the seller has done, the seller is entitled to be paid for his or her work in doing the “thing”.

Here’s an example from our files.

We had a client that supplied 10 Walmart stores with some specialty sporting equipment that her company created and wholesaled out. At the time, those 10 Walmart locations accounted for roughly 24% of our client’s $1.6 million in revenue. Around the time she called us, she was negotiating – to the degree any small business can “negotiate” with Walmart – to extend her Walmart footprint by an additional 17 stores.

We valued the business using both the existing Walmart revenue stream and, just in case she was successful in acquiring the other 17 stores as customers, the projected revenue stream for this expansion. Needless to say, the latter value was significantly higher.

As it turned out, our client got her Walmart deal signed and we brought the business to market at the higher valuation – even though the additional revenue would not begin showing up for months. We received very little push back on the higher valuation from any of the two dozen potential buyers.

In another simple example – this one of reducing expenses rather than increasing revenue – our client was able to cut the business’s operating cost in half by halving the rent his business was paying. In this example, our client owned the business AND the real estate the business used and, as I’ve discussed previously, the business paid an above-market rental rate to the owner; a way for the owner to legitimately get some additional cash out of the business in a tax-efficient way.

Yes, our process of recasting that business’s earnings would allow us to spot and adjust for this monthly over-payment. But if it appears on the financial statements, it becomes more “real” for the buyers.

The Bottom Line

While it’s rare, there are occasions when valuing a business based on its potential is a legitimate way to arrive at a justifiable value. And “justifiable” is what you need.

Remember that buyers are going to try to find all the holes in your valuation. You can’t deliver a marketing package with “pie-in-the-sky” assumptions or unrealistic numbers. And you particularly can’t expect the buyer will readily pay for any potential if that buyer has to do the work necessary for that potential to ever be realized.

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.

Joe

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