Four Truths of
Business Valuation
Truth #1: Valuation is highly subjective!
When I first started down the path of getting certified to do business valuations, my math brain was excited to learn some concrete FORMULAS to help apply an accurate value to a business.
On day one however, much to the chagrin of my math brain, the course instructor uttered the words heard most common in the valuation world – "Valuation is as much an art as it is a science".
But unfortunately it's the reality. A valuation is a “perfectly imprecise” process. There are so many different facets to a business, that putting an exact, precise value on a business, and having everyone agree on that value, is a near impossible task.
As I’ve said to many clients – you can have 5 different valuators do a valuation on your business, and it is likely you will get back five different values (although you hope they'll be within a reasonable range of each other).
What's the point in having a valuation done then? Well, it's a professional opinion. We've done a lot of them, we dive deep, and we will very likely look at certain details that you maybe have not been considering.
Furthermore, a "good" valuation is not one that simply gives you "a number"; rather one that arms you with information, and prepares you for negotiations ahead so that there are no surprises.
For this reason, we sit down with our clients on every single valuation we do and walk through each and every aspect of what we feel is driving the value. We lift the veil on how we arrived at our opinion of value, and provide the opportunity for a counter opinion.
Truth #2: A buyer is buying the future
A common gap between a seller’s value expectations and those of a buyer is created by this concept.
Very often, a seller has been so heavily involved in the building of their business – all of the long hours, the stress, the gains, the losses, the time away from family... EVERYTHING, for YEARS – that they go into the selling process with a mindset that it is worth ‘x’ because of all the hard work that has gone into it. In other words, they're focused on the past.
And while all of that work does hold value, and the "history" of the business is often used to justify the value of the business and the asking price, the reality is that a buyer is not buying the past;
They are buying the future economic benefits the company is expected to provide them, and they're weighing those benefits against the risks of them continuing once you, the seller, are out of the picture. They are NOT looking at your business with all of the feelings attached that you are.
Further to that, purchasers are often looking at more than one opportunity to purchase. The Principle of Substitution states that "the value of a thing tends to be determined by the cost of acquiring an equally desirable substitute."
If a purchaser is looking at two businesses nearly identical in all ways, producing similar earnings, but one is priced at $1.5M and one is priced at $2.5M, which one do you think they will choose?
Now at this point you may be saying, "Yeah well so what. I DID put in all that work, and think my business is worth 'x' and so it's worth 'x'".
And maybe you're right. I have not yet done a valuation on your business and so I currently have no opinion on YOUR specific business. But very often, when this gap in value expectation exists, it's because of this concept. Worth being aware of.
Truth #3: Value is Inversely Correlated with RISK
We dive into this particular concept in more detail in this article which talks about the basic formula that governs value, but let’s look at an example.
As we just discussed, a buyer is buying the future. So once you have proved, for example, that your business produces about $500k/year in EBITDA let’s say, the next question in a buyer’s mind is, “Okay, then what are the chances that, once I take over this business, those profit-levels are going to continue?
If there is inherent risk in realizing the returns – and we’ll cover some examples of that just below – then the value will go down. Risk goes up, value goes down. Risk goes down, value goes up.
So are some examples of what creates (or eliminates) risk in a buyer’s mind? Here are a couple very common examples:
Owner-centricity:
This is arguably the first aspect a buyer is going to asses. How important are you as the owner in the day-to-day operations of the business? More importantly, how involved are you with the sales and customer relationships?
If it all centres around you and then you leave, how likely are the sales, revenues, profits going to continue at the same levels as they have in the past?
As a general rule of thumb, the more involved an owner is, the more risk is present, and the lower the value will be.
And it's worth noting too that perceived risk is the same as real risk in a purchasers mind. You, as the owner, might easily be able to say "there is no risk of things changing once I leave". But a buyer has no way to know for sure, and so to them, the risk is real. If you truly feel there is no risk, do what you can to prove and support the claim.
The Diminishing Power of ONE:
This particular point can apply to all sorts of aspects of your business including employees, customers, sales and marketing, suppliers, and so on. But for now, let’s look at customers.
If your business relies on only one or two customers for the majority of its revenues, this is known as a “customer concentration” issue, and from a buyer’s point of view, it will present a risk.
Again they will ask, once the owner leaves the business, what is the likelihood that the relationship with the client will continue?
Because if the relationship doesn’t continue, and that client was worth a significant amount to the business, then the business stops being the business it once was. This is another illustration of how the “future” can be very different from the “past”.
The way to fix this is through diversification. The more diverse your customer base is, the less risk will be present.
And tying it back to all other aspects of your business, the more you rely on only one source of something, the more risk you have present in your business.
ONE key employee, what if he or she leaves?
ONE channel for gaining new customers, what if that channel dries up?
ONE supplier for all your needs, what if that supplier stops supplying? Perhaps they get purchased by one of your competitors. These things happen, it's a risk.
Avoid the diminishing power of one at all costs.
Truth #4: At the end of the day, your business is actually worth what a buyer will give you for it (which depends largely on your ability to present and negotiate it).
The TRUE value of your business is what someone will give you for it; what it actually exchanges for in dollars in an arms-length deal or transaction.
When it comes to purchasers, except for strategic buyers who may be searching for something very industry-specific, many buyers are less concerned with specific industries, and more concerned with cashflows and other characteristics of a “solid” business or investment.
So if you own an HVAC company for example, the market you’re in, your "competition" when marketing your business for sale, isn’t necessarily all other HVAC companies. Instead, it's more realistically all other companies in your area PERIOD.
And it doesn’t even have to be in your area – a buyer could be looking for a good opportunity anywhere across the province, or even spanning a few different provinces, like all of Western Canada for example.
Understanding that, it becomes important to realize that when selling your business, you’re competing with so many other businesses for potentially the same buyers.
When a buyer is assessing your business / opportunity, if you have your business “overpriced”, it is very easy for the buyer to say, “Well, why would I pay you 5x multiple, when I can buy this other one over here that is producing similar cashflows and only asking a 3x multiple?” So the Principle of Substitution really does keep sale prices honest, and again, no matter what a valuation says necessary, what it is truly worth is what a buyer will give you for it.
WANT TO LEARN MORE?
The unfortunate reality of this process is that there is a lot that can wrong, and you only have one shot to get it right... otherwise it can turn into a very costly and unpleasant experience!
Download our report on the "11 Common and Costly Mistakes" people make through the selling process, and set your self up for success from the beginning.
