Realistic Business Valuations
Understanding Business Value is the First Step to Exit Planning
One of the reasons that 83 percent of exit strategies fail is that owners have unrealistic expectations of the true value of their business. Over the years, I’ve come to realize that this error is caused by a number of factors. Let’s talk about some of them. By the way, this blog is taken right out of my book - Maximize Business Value, Begin with the Exit in Mind. Here is the link to get a copy of it or scroll up to see it right on our website's menu.
First and foremost, there is precious little data regarding transaction statistics, particularly as it relates to non-publicly traded companies. The only real news that people can find on a regular basis is from large publicly-traded company acquisitions, or some disruptive technology company sale, or investments made in “unicorns.” A unicorn, of course, is what the investment world calls a private company, typically a startup, that has a valuation north of one billion dollars.
I won’t get into my opinions regarding unicorns. Purely based on my definition above, these unicorns are able to attract investors at their valuation so it would appear that the valuation is valid—at least to the people writing those checks. Those valuations are wildly inflated compared to any other reasonable valuation method. Therefore, due to the publicity surrounding them, people are left to draw their own conclusions about this valuation being the norm.
Of course, if a company has some wildly disruptive technology or business model—think of companies like Airbnb, Uber, or Tesla—no rules regarding valuations really apply. Again, because of the massive press around these types of companies, the average person is driven to think that these valuations are the norm for all businesses, rather than the exception.
Next, The Retirement Requirement
One of my favorite valuation methods is the “what I need to retire” method. Don’t laugh. I did the first time I heard this requirement years ago, but it’s really more common than you think.
Several years ago, I was leading a massive rollup in the retail technology space. My team was buying companies at a pretty healthy clip. We used a clearly defined, proprietary valuation method that made it very easy for us to make an offer and cut right to the chase regarding whether a seller was serious or not. We typically wound up purchasing about one in ten of the companies with which we talked. For most companies, we never got to an initial offer, but for the ones we did, it certainly led to some interesting conversations. One, in particular, stands out.
We were looking at a software company that would have been a great tuck-in. These transactions are also called a bolt-on, which is an acquisition that adds value and can be rolled into an existing business. It had about $900 thousand in revenue and had been losing money for several years. Based on our valuation model, we could get somewhere between $750 thousand and $1 million for our initial offer, not bad for a company that had been bleeding red ink for a long time.
When I tossed that offer to the owner, his response was that the company was worth about $4 million. At this point, I started probing about how he came up with that valuation hoping that we could find some common ground, and his response was classic. “Well, that’s what I need to retire.”
On the inside, I was screaming “REALLY? That’s your valuation method?” But what I said was “Well, most buyers are not particularly altruistic in their valuation methods. But if that’s what you need, give me another thirty minutes and I’ll tell you how to get there. If you follow my advice, you’ll be worth that much in two or three years, and I’d be happy to pay that price, or even more if you achieve the results.”
I then proceeded to outline the changes that needed to be made in his business, and before we hung up, we agreed that he would reach out in a year with a progress report. So, what happened when he called? Sorry, that’s a trick question. Of course, he didn’t call. He was too busy living his lifestyle business to make the necessary improvements to get his valuation. Last I heard, his revenue had dwindled even further, and the company may have ultimately folded. It’s a shame, really. I was hoping he’d turn it around and sell it to me.
How About The X Factor
Another fun and common valuation method I hear on a regular basis is the “We’ve invested X dollars, and so we need at least that to sell the business.” Now, if you’re genuinely a unicorn with some disruptive technology, that requirement might be a valid valuation method. Then again, if you genuinely have a disruptive technology, you’re probably not looking to sell the business for merely what you’ve invested.
Several years ago, I had a conversation with a company looking to sell because their shareholders had investment fatigue, a frequent outcome when companies fail to achieve projected results and early investors want out. In reviewing the financial performance of the company, I learned that they had invested capital of nearly $10 million but had only delivered a few hundred thousand in annual revenue.
The company had existed for a number of years, and the owners poured their investment into product development. Granted the product was pretty slick, but it was by no means disruptive. It was an “also-ran” in a particularly crowded space. Had they delivered the product soon after they started, they had a chance to be a leader. But it took so long to develop that there were already too many entrenched products on the market, and their relevance was waning.
In talking with the company, I told them the painfully obvious. “It’s just not worth what your investors have put into the business, so either they need to be willing to take a huge loss or make additional investments to get the sales engine off the ground.” That launched into what I lovingly call the Shark Tank conversation. You know the one from the popular television show. A person comes in to pitch a startup, has a wildly inflated and unsubstantiated valuation, and Mr. Wonderful, Kevin O’Leary, pounces. I love that part. Many times, I find myself laughing at his methods, but his message is usually spot on.
Country Club Valuations - One of my favorites
There is the phenomenon of the Country Club valuation. This is the one that’s really hard to overcome. It starts when your buddy at the club sells his business and the buzz starts about how much he got for his business. “I heard he got $10 million. I know my business is worth more than that, so my asking price is at least $10 million.”
There is so much wrong with that valuation, I don’t even know where to begin. Was your buddy in the same business? What were his revenue and EBITDA compared to yours? Was his business in a hot market? How did his company’s operations compare to yours? What about his preparedness to sell his business?
I could go on and on and on. Typically, and interestingly, there is probably no basis for the rumored $10 million sales price. Your buddy probably never actually told anyone what he got for his business, but when someone tossed out the $10 million figure, he just sheepishly grinned. The news spread like wildfire in the club, and the fish tale got bigger every time.
It’s sort of like the telephone game we all played as kids when you sit in a circle and the first person whispers something to the person on his right, who whispers it to the next person, and so on until it gets back to the original person. By that time, the message has changed so dramatically that it’s usually unrecognizable. Don’t be fooled by country club valuations. They are rarely based on fact.
Finally - Professional Estimates
The best solution is to prepare your business for sale by planning ahead. Get a regular estimate of value from a professional who does that for a living. Really good investment bankers and business brokers will usually provide an estimate at a minimal cost or in some cases free of charge. They are going to take all of the right factors into consideration and compare it to data that is not readily available on the open market.
We, here at Mastery Partners, provide this analysis as a matter of course. We offer it in 3 flavors. First, we offer an express valuation for free right on our website. Second, we have a more detailed Estimate of Enterprise Value for a nominal cost, and finally, we offer a very detailed Opinion of Enterprise Value as a part of our 4-Step Process to help business owners build long-term value and achieve a satisfying exit. Of course, if you need a valuation for a dispute, engaging a professional valuation is the best way to get one that will hold up in court - but that typically comes at a hefty price. For the typical purpose of planning, an estimate or opinion of enterprise value is a great place to start. With this estimate in hand, you can develop a long-term strategy for the future.
If you don’t know what your business is worth today, get a valuation! It’s a great place to start so you know the truth and not guessing! You can get one for FREE right on our website.
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ABOUT THE AUTHOR
Tom Bronson is the founder and President of Mastery Partners, a company that helps business owners maximize business value, design exit strategy, and transition their business on their terms. Mastery utilizes proven techniques and strategies that dramatically improve business value that was developed during Tom’s career 100 business transactions as either a business buyer or seller. As a business owner himself, he has been in your situation a hundred times, and he knows what it takes to craft the right strategy. Bronson is passionate about helping business owners and has the experience to do it. Want to chat more or think Tom can help you? Reach out at firstname.lastname@example.org or check out his book, Maximize Business Value, Begin with The Exit in Mind (2020).
Mastery Partners, where our mission is to equip business owners to Maximize Business Value so they can transition their business on their terms. Our mission was born from the lessons we’ve learned from over 100 business transactions, which fuels our desire to share our experiences and wisdom so you can succeed.