Business Valuation Checklist: 3 Traps to Avoid

Executive Summary

What are the three most common mistakes business owners make when valuing their business?

Valuation Trap #1: The Unnecessarily Complex Valuation Trap

Most business appraisals are written for those involved in litigation or other legal matters. These appraisals use complex language that is difficult to understand and include methods that are of little practical relevance to a business owner wishing to sell. If you are selling your business and you want a valuation, is an appraisal right for you? If so, what type of appraisal should you get?

Valuation Trap #2: The Third-Party Valuation Trap

Several business appraisers offer their appraisals through a network of business brokers. These networks actively market their services to business brokers, charging as little as a few hundred dollars to the brokers, while the brokers may charge their clients what they please. Should you pay for a third-party appraisal?

Valuation Trap #3: The Free Valuation Trap

Why do business brokers offer free valuations? Should you trust an appraisal that you receive for free?

The appraisal obviously plays a key role in determining the value of your business. That’s why it’s important to not waste time and money on unnecessary features and instead focus on what will best help get your business sold. The article that follows will help you do just that.

Valuation Trap #1: The Unnecessarily Complex Valuation Trap

Most business appraisals are prepared for legal purposes, and the primary audience for these valuations consists of lawyers rather than business owners. A business valuation for the sale of a company should be written in a way that is useful to the business owner (the seller), as opposed to an attorney.

The valuation is a critical component in the process of selling a business, so it should be written with an understanding of the process of buying and selling a business and specific knowledge of the marketplace, as opposed to arcane legal standards.

Unfortunately, most business appraisals are written for those involved in litigation or other legal matters. These appraisals use complex language that is difficult to understand and include methods that are of little practical relevance to a business owner wishing to sell.

For example, most appraisals contain an in-depth analysis of industry and economic factors that may affect the value of a business. This level of detail is required for appraisals intended for legal proceedings (such as bankruptcy, divorce, or estate and tax planning) but is not necessary for owners who are already familiar with the industry and economic factors that may affect the value of their business. There is no need to pay an expert to prepare a report to discuss factors with which you are already familiar or do not need to understand.

Appraisals must follow guidelines and standards, and many of these guidelines and standards require the appraiser to analyze and document a multitude of factors that have no relevance in the actual marketplace.

In addition, guidelines are in place that require appraisals to comply with the specific requirements for different types of legal proceedings. For example:

An appraisal for a divorce may require a strict definition of value, such as “fair market value,” whereas an appraisal for another purpose may require the standard of “fair value.”

Such differences may seem minute, yet appraisals must follow these exact standards if the purpose is for litigation or other legal matters.

As the business valuation industry has progressed, standards have become more complicated, and the standard business valuation report has lengthened over the years. As a result of this increased complexity, it takes more time to prepare a report following these standards, resulting in an increased cost.

Due to the numerous legal requirements that appraisals must now comply with, most business appraisals are of little practical use to a business owner because they are too obscure and filled with legal jargon that has no relevance in the real world.

Nearly all appraisers use commercial software when preparing a valuation, while some have produced their own software. Most of this software is specifically designed to produce valuations for legal purposes. You will have difficulty finding an appraiser who uses valuation software designed for the purpose of selling a business. Unfortunately, the reports produced by most valuation software are highly technical and not of much use to you as a business owner.

We recommend seeing a sample report from an appraiser before engaging that appraiser. Read it to see if you can understand it. If you can’t, then you are wasting your money. Remember, the appraisal should be written for you, and if you can’t understand it, then you’re throwing your money down the drain.

Many business brokers and M&A intermediaries do not have in-depth working knowledge of these standards, so they decide not to offer business valuations as a service.

Subsequently, most of the people offering business valuations are business appraisers and CPAs, many of whom have never sold a business. Few have an understanding of the process of buying and selling a business, and few understand the marketplace for the exchange of companies. As a result, there is now a great divide in the valuation world — business brokers and M&A advisors don’t like to prepare appraisals because of the increased theoretical complexity, while most business appraisers and CPAs have no experience selling businesses.

This raises the question: Would you pay an appraiser thousands of dollars to determine the value of your business if that person had never sold a business?

Valuation Trap #2: The Third-Party Valuation Trap

Several business appraisers offer their appraisals through a network of business brokers. These networks actively market their services to business brokers, charging as little as a few hundred dollars to the brokers, while the brokers may charge their clients what they please.

Many franchised business broker offices push their franchisees to sell third-party appraisals, which are simple to sell and can be sold at a markup of two to five times above cost. Brokers make this recommendation because they can sell the valuation at a large markup and don’t need the expertise required to appraise a company.

Business appraisals are difficult to prepare. That’s largely why franchisees can be persuaded to sell them but not prepare them. The drawback is that you never interact directly with the appraiser, and many brokers don’t understand the contents of the report.

While the report may be valuable, many brokers may incorrectly explain the elementary assumptions and components of the report, thus rendering the report useless for most business owners. After all, what good is a valuation if you can’t understand it and the broker can’t explain it?

Third-party appraisals are beneficial for only one party — the broker. As a broker, since you aren’t doing the appraisal yourself, you need absolutely no appraisal experience to sell an appraisal to a client.

You can sell them to clients at a markup of up to five to 10 times what they cost you. A business broker can get started today with no industry experience or investment and immediately start selling third-party appraisals to unsuspecting clients at a high markup.

A broker who owns a business brokerage office has it even better. They can hire new associates who have zero experience or knowledge and have them also start selling business appraisals. There is no need to train the brokers. They can hire anyone, no matter their background. By selling a third-party appraisal, a broker needs no specialized knowledge, experience, or certification, and neither do their associates.

Why not just hire the appraiser directly at 10%-20% of the cost?

If a broker were to recommend a third-party appraisal to you, ask the name of the company they use. Then ask if they can put you directly in contact with the appraiser. They may respond by claiming that the appraiser only works through brokers. That’s a cover-up — it’s unlikely the appraiser only works through brokers. Then, ask the broker what their markup is, if any. There should be no reason for a broker to hide the amount of their markup. If they do attempt to hide their cost, and if the broker you are talking to can’t be transparent, then we shouldn’t have to tell you this, but: Look elsewhere.

Valuation Trap #3: The Free Valuation Trap

Brokers carefully prepare “free” valuations to ensure that they meet your expectations of value as opposed to the expectations of the buyer. In other words, they tend to artificially inflate the value of your business so they can obtain you as a client.

Brokers sometimes openly discuss how “honest” they could be with prospective clients (sellers) that they did not want to lose as clients. At times, brokers playing with the valuation formulas tweak the results to please potential clients. In private, they will say things like, “No, we can’t tell them that,” or, “Why don’t you try tweaking that formula a little bit?”

Later on, of course, you will be told that your business is not worth what they initially said because of something you failed to disclose. At that point, however, you are already committed and have invested a significant amount of time and energy with a broker. Unfortunately, you’ve also signed a contract and will have to wait until it expires to continue the process with another broker. Many brokers also include a cancellation clause in their agreement requiring that they will receive their commission in full if you attempt to cancel the agreement, so this leaves you with few options other than accepting a price reduction.

Artificially inflating the value of your business sets up false expectations for you by leading you to expect to sell your business for more than it is worth and start the relationship off on the wrong foot. Don’t fall for it.

Why do business brokers offer free valuations?

First, obtaining clients is easy if you offer a free appraisal. There are enough business owners who are willing to be duped by something that is free. Second, the industry has a low barrier to entry. As a result, new entrants to the industry offer free valuations, and others blindly follow suit.

The question then becomes: Are you willing to hand over one of your most valuable assets to someone who is willing to dupe you into a relationship based on a false pretense? A long-term relationship like this should be based on a solid foundation of trust, honesty, and transparency.

Through the years, we’ve learned that the more knowledgeable and experienced an expert is, the less likely they are to offer anything for free. After all, how much does someone value their advice if they are willing to give it away?

Are free business appraisals common in the middle market? No. They are rare. The majority of M&A advisors selling businesses valued between $5 million and $50 million do not offer any form of free valuation. In our random survey of 44 CPAs, appraisers, and M&A intermediaries, only one offered a free valuation to prospective clients. The rest charged between $2,000 and $40,000 for a business valuation.

How can you avoid the “free” valuation trap?

What can you do to avoid this “free” valuation trap? Be wary when you see a professional aggressively advertising a free service, especially if that individual also works exclusively on commission.

Tips for Avoiding the Traps

Here are your options for avoiding the three valuation traps:

1. Hire a business appraiser to perform a verbal opinion of value. This is a good option, but this is only a wise course of action if the appraiser has actual experience in selling businesses. Otherwise, the appraiser’s knowledge is largely theoretical. Most business appraisers prepare business valuations for legal purposes and have no experience in selling companies.
2. Hire a CPA to provide a verbal opinion of value. Again, this is a good idea only if the CPA has real-world experience selling companies. Your typical CPA may not have been trained to perform a valuation, so be sure you understand your CPA’s experience. Otherwise, as pointed out above, the advice you will receive may be largely theoretical. When valuing a company, it’s critical to have your fingers on the pulse of the market and to understand the subtle nuances that could impact the value of a company. Most professionals without any M&A experience lack this fundamental practical expertise. You need practical expertise here, not theoretical.
3. Hire an actual deal-maker, such as a business broker, an investment banker, or an M&A advisor, for an opinion of value. This is your best option. However, if you are approaching a commission-based deal-maker, it is best to tell them that you are considering a potential sale in the future, not now. Doing so will increase the likelihood that you will receive an unbiased opinion on your company’s value. Because of the deal-maker’s real-world experience, this option is still far superior to receiving a free valuation from an inexperienced broker.

Remember that although valuations are being offered to you for free, you will still have to pay for them one way or another. A free service always comes with a price — and it’s often more expensive than the paid, transparent service.