A Few Business Owner Valuation Pitfalls
“Beware of geeks bearing formulas.” Warren Buffet
Valuations are part science, math, craft and art. Don’t make assumptions about universal or common approaches to valuation. EBITDA is a great example. View it as a fixed benchmark of value and the multiples that are applied to it as a cookie cutter standard for valuation at your own risk. It’s very useful to understand how the investor views the factors that both mitigate and provide context for EBITDA. Just a few of these factors include current enterprise value (EV), tax position, cash flows, debt service costs, the amount and nature of capital investment requirements and/or the ratio of future investment to profits, discrete patent and intellectual property valuations … How does the investor view these issues in relation to your companies EBITDA? How do you view them? The point is that most valuation formulas require context and subjective analysis. It’s important to understand a buyer/investors underlying valuation rationale and it’s just as important to have one of your own.
“Torture numbers, and they’ll confess to anything.” Gregg Easterbrook
One of the obvious examples of unsupported value is a forecast of sales growth unsupported by past performance, product innovation, product line extension or verifiable market changes. Projections of sales and growth need to be firmly grounded in business realities, not an entrepreneur’s aspiration. In short the valuations based on wishful thinking are not received favorably. This is my Baby!
We find that business owners who have spent the better part of their professional life building a business are vulnerable during valuations. All too often their love for their business seeps into their view of valuations in some very obvious and some very subtle ways.
We hear statements like:
• “My business is more than its balance sheet”
• “They don’t understand my business”
• “I’ve got my flesh and blood in this business and they offer…..”
The difficulty we have in dealing with these sentiments is they usually have a lot of truth in them and even more emotion. Some private equities are highly skilled at managing and finessing this seller mentality while others can look a father in the eye and tell him his daughter is just not that pretty, without hesitating or blinking.
Having said this, there is a lot of value in a business that has built a strong reputation over a long period of time. Having satisfied employees, shareholders, vendors and most importantly customers, adds significantly to your value! Many company’s say it is the case, but some cannot substantiate those claims. By having the ability to quantifiably prove the company’s reputation and quality, you will increase your value!
Another problem is abstract futures. An abstraction might be that favorable future market shift you can just feel in your bones. That’s got to be worth something! Not much. Investors are not buying your bones. None of our Private Equities clients pay much if anything for abstractions. However, they do pay for well supported projections and upside. By finding facts and figures that support your claims you will be able to realize more value than a gut feel!
“The optimist sees opportunity in every danger; the pessimist sees danger in every opportunity.” Winston Churchill
It’s rare that a business owner and an investor will look at the same risk the same way. It’s no surprise that we find buyers are vulnerable to a pessimism bias whereas the seller is prone to an optimism bias. Recognizing these propensities makes the process of bridging divergent bias’s a lighter lift. Customer concentration is an excellent example. What exactly constitutes too much business from too few customers? What constitutes a customer concentration problem in the business owners’ eyes may be very different from the view of a buyer. When a business owner lives with and successfully manages a business risk over time they may be inclined to minimize its ultimate significance in valuation and other aspects of a transaction.
In order to have a buyer understand some of this value it is important to understand the buyer. Knowing they are looking at the business from a “what are the risks?” perspective will help you address problems upfront. Making a buyer more comfortable with the risk and explaining why it may be palatable that it seems can go a long with in building their confidence in investing.