12 May Business Valuation – What is the true value of your business?
Want to know the value of your business? Pose the question to your closest friends and advisors. First, write your answer down. You will be amazed at the range of responses. Go one step further and ask each person how their answer was determined.
Despite the fact that value and valuation are a foundation of our economic lives and free-market system, the concepts of business valuation remain misunderstood and are frequently misapplied. It can be said that only a few people possess a true working knowledge of valuation. They do so by combining their knowledge and market experience with risk capital.
There should be little wonder why valuation is shrouded in confusion. Aside from basic microeconomic theory, our high schools and colleges don’t teach it. Contrary to common belief, the basic curriculum for accountants and attorneys does not include business valuation. Most graduate business schools only cover the valuation of publicly traded securities, which is only partly relevant and misleading to the valuation of privately-held mid-size businesses. Many would be surprised to find that bankers are not trained in business valuation and would rarely, if ever, look at business value when assessing a loan.
Business valuation demands that you consider three important questions: Value to whom? Value as of what date and what is the definition of value? Consider the following:
Value Is Subjective:
Valuation is not and cannot be exact – it is subjective and will be a different number for two different people. It is like beauty, as they say, “in the eyes of the beholder.” What is the value of the watch your wife gave you? What is the value of your father’s 1971 Lincoln Continental that has been sitting in your backyard for the past eight years? What is the value of your business to a buyer who could grow the business and increase profit margins if it were combined with his or her own business? And how do you quantify that value?
Few people are exposed to real and representative business sale data:
The fact that few of us buy and sell businesses means that few have sufficient experience to offer a meaningful valuation. Businesses are not bought and sold as frequently as real estate or cars. And when they are, the data is much more complex and usually confidential. In addition, data becomes out-of-date quickly, as fluctuations in the health of the economy and industry cycles cause significant fluctuations to the price multiples buyers are willing to pay.
High interest and little factual data breeds misinformation:
For whatever reason, people in our culture are immensely interested in other people and money. Business sale transactions involve people and a lot of money, so there is much interest in the sale price of a business. Business sale data is rarely made available so misinformation fills the void. This phenomenon is well documented in research studies. Add to this the fact that the buyer or seller may allow or even encourage inflated and inaccurate information that may put him or her in a favorable light.
Complexity of business sale transactions and the importance of “terms”:
Unlike cars and houses, businesses usually don’t sell for 100 percent cash at closing. And it is common for the price to be contingent on certain events occurring after the date of sale. As such, the actual sale price is often very difficult to determine and is different from the cash price paid at closing. In these cases, the actual sale price can only be determined after all contingent events occur and the payments of the “terms” are made.
Each Business is One-of-a-Kind:
Most things we buy have identical or close substitutes. Even a used car or most houses can be considered to have close substitutes. This makes the valuation task easier because we can compare it to others with similar characteristics. In contrast, businesses are unique. They rarely have close substitutes. Therefore, applying the “comparable sales” method is more challenging. There is no definite answer unless the business is sold. And even then, unless a seller hired a skilled professional and secured multiple offers, there is no guarantee that the price paid was a fair value.
And since the valuation task is often separate from the sale of a business, the most you can hope for is a fair value estimate. If you are preparing your business for sale, your priority should be to hire a firm that is capable of finding the highest and best buyers, securing multiple offers and giving you the peace of mind that the final sale value you agree to has been tested in the market with a thorough and professional process.