Critical Valuation Concepts

Why is there such a wide range of values for businesses? The simple answer is because a valuation is one person’s opinion. An opinion of value can vary based on who performs the appraisal, what they’re looking for, and the methods they use. Let’s explore the many reasons behind why businesses can have a wide range of potential values. 

Concept 1: Information is Limited

Comparable Transactions Are Often Unreliable

The ideal way to value your business is to determine what similar businesses have sold for. Unlike residential real estate transactions – where it’s not difficult to find recent sales of homes like yours – there have probably been few, if any, recent sales of businesses highly similar to yours. While information is readily available on public companies, there are vast differences between valuing private and public companies. The market for businesses is fragmented, making it difficult to obtain relevant comparable transactions, and information is limited. The market for mid-sized businesses is inefficient, and intelligence is scarce, to say the least.

All Businesses Are Unique

Additionally, all businesses are unique. Even if you’re able to find a somewhat similar comparable transaction in your industry, the business won’t be the same as yours in terms of risk, growth rate, location, sales volume, number of employees, and a host of other critical factors that can affect the price.

Availability of Accurate Information

The information available in transaction databases for small and mid-market transactions is often submitted without being verified, and only pieces of the story are provided, such as high-level financial details. Critical transaction information may be missing from the database, such as the terms provided, how EBITDA was calculated, whether the parties are related, and other relevant information. This makes it challenging to adjust transactions to make them truly comparable.

Even in the unlikely event that you can find the recent sale of a company that closely resembles yours, you may not be able to access accurate numbers on the business and the transaction. Unlike real estate sales, which often leave a public paper trail, business sales numbers are private. Access to accurate information can be hard to come by, especially because rumor and exaggeration often obscure the facts.

Not only is information limited or biased, it can also be incomplete or inaccurate. Appraisers must rely on information from ownership or management, which can be biased, or on accounting and financial details, which are often missing pertinent data. As a result, an appraiser’s opinion of value will continue to evolve as they acquire new findings, or as their understanding of existing information changes.

Beware of Incomplete Information

Watch out for incomplete sales information, such as hearsay. Attend any business event with others in your field, and you’re sure to hear that so-and-so sold their business for such-and-such dollars. 

At a business lunch, for example, you may learn that Emma received $10 million for her business. Even assuming this number has some truth to it, and it may not, you may not be told other noteworthy details. For example, the reports of the sale price may not mention that Emma agreed to work for the buyer for three years, which was included in the purchase price, or that the price included the real estate, or that Emma received only 15% of the purchase price upfront with the rest to be paid over five years, or that 80% of the price was based on an earnout. 

Value Is Only Determined in a Sale

A key task in selling any business is figuring out how much it’s worth. If you expect precision in pricing your business, you’ll be disappointed. No pricing formula or expert can accurately provide a sales figure that’s exactly “right.” So, while you need to price your business sensibly, you won’t know how much it’s really worth until the day a buyer writes you a check.

Price does not equal value. The actual value is only determined when a business is sold. Just because your company was valued at $100 million doesn’t mean it’s worth $100 million until someone actually pays you $100 million. Just because your friend’s company was valued at a six multiple doesn’t mean your company is also worth a six multiple because you’re both in the same industry and have similar-sized businesses. Just because your uncle received an offer on his business for $100 million, which works out to 70% of revenue, doesn’t mean your business is worth $35 million just because it generates $50 million in revenue.

A comparable transaction must come from an actual transaction – not an appraisal, the asking price from a similar business, or other hypothetical non-transactions. 

Price does not equal value. The actual value is only determined when a business is sold. 

Concept 2: Predicting the Future Is Difficult

Market Variability Is Hard To Predict

The essence of valuation is predicting how other investors will behave, such as anticipating the price they’ll pay for a business. Even the world’s most respected mutual and hedge fund managers, with billion-dollar budgets and thousands of employees, whose sole objective is to predict the future value of publicly traded companies, can’t consistently beat the markets. 

In 2007, Warren Buffett bet $1 million that the S&P 500 would outperform a collection of hand-picked hedge funds. Buffett wasn’t betting against the “average” hedge fund. Far from it. Buffett allowed the opposing party to hand-select from among the best-managed funds in the world. Protégé Partners took him up on his offer and meticulously selected five hedge funds. What were the results at the end of the decade-long bet? The results were calamitous for the hedge funds. From 2007 to 2017, the S&P 500 gained over 125%, while the five hedge funds gained a paltry 36% in comparison. The bet was open to anyone in the industry that wished to participate, but only one stepped forward. And despite their ability to actively monitor the funds with the assistance of hundreds of analysts, their performance was crushed by a passive investment in an index fund that required no work and a staff of exactly zero.

What’s the lesson here? The market is impossible to predict, even for those with nearly unlimited resources who professionally manage billions of dollars. Fear and greed drive human behavior, and even the world’s best investors can’t accurately predict movements in the markets with any consistency. Even Warren Buffett, considered by many to be the greatest investor of all time, admits he can’t predict the price of a stock in the short term or even predict how the economy will do in the mid-to-long term. From the tulip bulb craze in Holland in the 1630s to the dot-com bubble in 1999, humans’ irrational behavior has proven impossible to forecast accurately. Predicting the behavior of a single individual is difficult enough, let alone predicting the impact of fear, greed, and herd behavior. Changes in the macroeconomic environment can have an enormous impact on the value of a business, and such changes have proven impossible to foresee.

Values Change Based on Markets

Because the marketplace for the sale of mid-sized businesses is inefficient, values can also vary widely over time. Therefore, current market conditions can significantly affect the final selling price of your business.

Estimating Future Cash Flow Is a Challenge

The fundamental premise of most methods of valuing a business is placing a value on expected cash flows. After all, a buyer is buying future cash flows, not historical ones.

Most projections prepared by owners of mid-sized businesses are based on assumptions that are impossible to substantiate. History isn’t an accurate representation of what’s expected to happen in the near future for any business, especially in a volatile or unpredictable economic environment. Assessing future cash flows for a business is especially difficult if there’s a lack of consistent, historical financial projections that have been met. Estimating potential growth rates is inherently difficult for any business, even one with well-documented and predictable growth, let alone a business with inconsistent financial results.

Not only must future cash flows of a business be predicted, but the potential risk of receiving the revenue must be assessed as well. Stuff happens. The presence of risk must be built into any financial model, even though risk is impossible to predict with precision.

When valuing a business, one must estimate the future cash flows as well as its potential for growth, and the associated risk. Such an estimate is subjective at best, even if it’s based on strong, historical financial results, and even more so if historical financial information is limited. The degree to which a business’s value is tied to future results – and the great degree of risk associated with estimating future cash flow upon which a business’s value is based – must always be considered when reviewing any business appraisal. 

The fundamental premise of most methods of valuing a business is placing a value on future expected cash flows.

The Impact of the Future Is Unpredictable

Future value depends on factors beyond our immediate control, but the impact of these factors can’t be predicted. For proof of this, look no further than the coronavirus pandemic, which no one saw coming and which threw most sectors of the economy into a tizzy. Price depends on demand, which itself depends on a wide variety of factors, from interest rates to constantly evolving consumer trends to the political landscape, and more. 

The economy impacts some types of industries to a great degree, especially those selling a discretionary product or service or companies that operate in a cyclical market. The impact of a protracted recession can be disastrous for cyclical businesses. Other industries, such as finance or healthcare, are susceptible to the impact of external factors such as governmental regulations, and one can only conjecture about their likelihood and potential impact. Our lawmakers – some with motives that are questionable – wield power that can determine the fate of many industries, which introduces an additional layer of guesswork for any business operating in such sectors.

Even the world’s most widely esteemed economists can’t predict the future trajectory of the broad economy, let alone the outlook for specific industries or businesses within those industries. Such a requirement introduces a level of uncertainty in any appraisal, so the best one can do is to make an educated guess based on a limited amount of information. These limitations on the ability to predict such uncertainties must be considered when weighing the merits of any valuation.

Concept 3: Buyers Have Different Criteria

Perceptions of Risk Are Subjective

The group of potential buyers for a business is diverse, thereby greatly expanding the likelihood of a wide range of opinions. For example, a lower mid-market business may have the following potential buyers – wealthy individuals, direct competitors, indirect competitors, financial buyers, and smaller publicly traded companies. 

The views, perspectives, expectations, and tolerance for risk among a diverse group of buyers can vary greatly, resulting in a wide range of possible values. The tolerance for risk also varies widely from buyer to buyer. Their opinion of value varies significantly as the price a buyer can afford to pay is a direct function of their assessment of the risk of the potential investment. A buyer’s assessment of risk may also be limited by their ability to acquire accurate information on the business and industry. The value of a business is ultimately determined by a buyer’s perception of risk, which can’t be accurately predicted or measured. 

Any valuation should first explore the potential universe of buyers, and then calculate a range of potential values those buyers may pay.

Lost Opportunity Cost Varies

The lost opportunity cost of an acquisition for any corporate buyer is the cost of not completing another transaction or other form of corporate development. Some examples of lost opportunity costs include not launching a promising new product when you had the chance, not forming a joint venture to strengthen your core operations, or not expanding distribution channels to sell more products. Because the lost opportunity cost varies from buyer to buyer, the value of a business will also vary from buyer to buyer, and such a variation adds another layer of complexity to any business appraisal.

Synergies Are Impossible To Calculate

The financial benefit of potential synergies is also impossible to accurately anticipate or assess. When selling a mid-sized business, the potential universe of buyers normally includes direct or indirect competitors who would stand to benefit from adding your offerings into their mix. Often, competitors bring synergies to the table in the form of potential increased revenue or decreased expenses. To properly value a business sold to a synergistic buyer, one must calculate the amount of the synergies so they can be analyzed and valued. 

As an example, if a company with an EBITDA of $5 million per year is purchased by a competitor that brings an additional $1 million in increased EBITDA in the form of synergies to the table, the valuation could look like this:

Before Synergies: $5 million EBITDA x 6.0 multiple = $30 million value

After Synergies: $6 million EBITDA x 6.0 multiple = $36 million value

Implicit in this valuation is that we know the amount of the potential synergies and, therefore, the post-sale EBITDA, which forms the basis of the valuation. In most cases, this information can’t be obtained by the seller. Buyers rarely will provide you with access to their financial models, let alone their reasons for the acquisition. As a result, you may not understand the buyer’s true motives for a transaction. Sellers are rarely privy to a buyer’s financial models, projections, or other analyses that can be used to calculate the amount of the synergies. The best you can do is to reverse-engineer the buyer’s potential synergies, estimate their value, and then negotiate the highest purchase price possible, ideally with multiple buyers in the form of a private auction. 

A valuation based on synergies is, at best, an educated guess and normally only serves as a baseline upon which the company may be valued. Any excess of the baseline value can only be achieved and determined in the actual marketplace through a competitive marketing process.

Buyers Don’t Always Follow Valuations

Keep in mind that an appraiser is making an educated guess as to what a hypothetical buyer might pay for your business. That’s why estimating the value of a mid-sized business is difficult – you’re speculating on how a diverse group of investors will think and behave. This is an inherently onerous task, regardless of one’s expertise and knowledge.

Concept 4: Valuation Methods Are Subjective

Appraisers Lack Real-World Experience

Most business appraisers lack an essential requirement – experience. Few have ever sold a company in the real world, yet despite that, their job is to make an educated guess as to what a hypothetical buyer will pay for a business. While most appraisals are commissioned for tax or legal purposes, those intended for selling a business should be prepared by a professional with real-world experience in the marketplace, such as an investment banker or M&A advisor.

Compensation Can Impact Objectivity

M&A advisors’ form of compensation may also affect their opinion. If their estimate is too low, a potential client may go elsewhere. As a result, an advisor may pad their opinion to avoid losing a client and then later backtrack on the valuation in an attempt to bring the owner back into the “real world.” Interests should be aligned whenever possible, and the true beneficiary of any valuation should always be questioned. 

Most business appraisers lack an essential requirement – experience.

Cognitive Bias Clouds Rational Judgment 

Humans are biased, and analysts are no different. Not only must an appraiser deal with an enormous amount of uncertainty, but they must also cope with their own preconceived opinions and notions, which are often subconscious and therefore undetectable.

Here’s a list of cognitive biases and potential examples that may surface when valuing a business:

• Confirmation Bias: The appraiser seeks information to confirm their bias. For example, they may have a long-term belief that the range of multiples for radio stations is 8 to 10 times EBITDA, and they may ignore information that doesn’t support this bias. They may form an initial opinion regarding the value of a business and then fiddle with the valuation to ensure it aligns with their initial expectations.
• Recency Bias: The analyst may assign more weight to companies they have appraised or sold recently and forget about data or transactions that aren’t recent.
• Anchoring Bias: The appraiser first learns through another appraiser, who’s widely considered a leader in the field, that multiples in the aerospace industry are in the range of 9 to 10 times EBITDA. This becomes the “anchor,” and the advisor then seeks information to confirm this anchor, ignoring factors that conflict with the anchor.
• Availability Bias: The appraiser may place too much emphasis on data that’s readily available and not perform an exhaustive search for information that’s less available.
• Conservatism Bias: The appraiser may cling to their long-held belief that multiples never exceed 6.0 if EBITDA is below $5 million, and then consciously ignore information that doesn’t support this personal belief.
• Contrast Effect: The investment banker may hear of a transaction at a 10.0 multiple in an industry in which they’re valuing a business, so they push up their estimate to a 6.0 multiple from 5.0. After all, an increase in the multiple by a factor of one “isn’t a big deal” if a larger company in a related industry sold at a much higher multiple.

In preparing any valuation, an advisor should attempt to be aware of their biases and make efforts to mitigate the impact of their biases on their opinion. Readers of appraisals should also be aware of the potential for biases in any valuation and be cognizant of the impact such biases can have on the appraisal.

Concept 5: Significant Time and Effort Are Required

Software Isn’t Designed for M&A Valuations

Most software to appraise businesses is designed for legal or tax purposes. The methods used in the courtroom are different from those buyers use in the real world. Most software is inadequate for addressing a variety of situations and must be designed to handle the highest level of complexity the appraiser might encounter. An appraiser can be faced with having to arbitrarily input information into a program simply because it’s required by the software, despite it being irrelevant to the business’s stage of growth or industry. For example, many appraisal software programs analyze key financial ratios, such as debt to equity. These ratios may be irrelevant for a small manufacturing company in which the transaction is structured as an asset sale.

To avoid this arbitrary information, many investment bankers use their own spreadsheets of factors suited to the client and business they’re valuing. For owners considering a sale, an M&A advisor’s oral opinion can sometimes be more valuable than a written appraisal. 

At Morgan & Westfield, for example, we combine a financial assessment of the business with an exit strategy and an in-depth consultation with the owner to develop a full understanding of the business. We then explain our opinion of value in detail during a phone call with the owner. We can best assess and communicate our opinion of value if we aren’t encumbered by the built-in limitations of external software. 

If you’re considering paying for a written appraisal, ask for a sample report. Be sure you can understand it and that the information is relevant before you pay for a valuation.

Valuations Take Time and Effort

Properly valuing a business takes a great deal of time, especially when it comes to understanding and predicting future cash flows. The more sweat equity that’s invested in preparing the appraisal and predicting cash flows, the more accurate the valuation will likely be. But most business owners understandably don’t want to pay tens of thousands of dollars for an advisor to spend hundreds of hours developing an understanding of their business. As a result, many valuations, particularly oral valuations, are predicated on input from the owner or management team, who have inherently biased views.

Even if sufficient time is spent understanding the business and the sub-sector, how accurately can future cash flow be predicted for a business? The best one can do is to make an educated guess. A business is highly dependent on the aptitude and drive of the entrepreneur and predicting the long-term drive of one individual is difficult, to say the least. 

The value of any appraisal is in direct relation to the skill and experience of the appraiser and the amount of time they spend understanding your business. As a business owner, you should be aware of such limitations and accept that you’re paying for a professional’s opinion, and the accuracy of such an opinion is related to the amount of time and effort spent by the appraiser.

Concept 6: Fair Market Value vs. Strategic Value

Two standards of value a buyer might use to value a company are fair market value and strategic value. Next, I’ll describe how each of these methods might drastically change how a buyer may value your business.

Fair Market Value

Most business appraisals use fair market value (FMV) as the standard of value. The real-world understanding of “fair market value” is as follows:

The highest price a business might reasonably be expected to bring if sold using normal methods and in the ordinary course of business in a market not exposed to any undue stresses. That market is composed of willing buyers and sellers dealing at arm’s length and under no compulsion to buy or sell, with both parties having reasonable knowledge of the relevant facts.

Explicit in the definition of fair market value is the following:

• Amount (i.e., Price): The prevailing standard in business transactions is the highest price, whereas in real estate transactions, the standard is the “most probable price.”
• Willing: The definition implies that the parties are willing and able, have sufficient motivation, and are acting in their best interests.
• Compulsion: FMV assumes the parties are “under no compulsion” to complete a transaction and that they’re dealing with one another at arm’s length, not influenced by special motivations.
• Knowledge: Fair market value assumes the parties are well-informed and possess reasonable knowledge of the industry, marketplace, and the opportunities and weaknesses of the subject business.

Strategic Value

Strategic value, also called investment value, is the worth of a business to a specific buyer. It can represent an amount in excess of FMV to a specific buyer of a business, usually a strategic buyer. The primary downside to strategic value is that you can’t measure it until you know who the buyer is. That’s because every buyer will extract a different amount of value from your business based on the synergies they bring to the table.

For companies likely to be sold to a strategic buyer, a valuation will only serve to establish a “floor,” or a minimum price, or fair market value at which the company may sell. It’s possible your business may sell for more if it’s purchased by a strategic buyer. 

It’s impossible to quantify the synergies until you identify the buyer, and many times you can never quantify the synergies, as most buyers hold these in confidence throughout the process to maintain their negotiating leverage. For mid-sized businesses, the purpose of the valuation is only to establish a minimum floor price or fair market value. The true value, or strategic value, can only be determined in the actual marketplace by establishing a competitive auction process among buyers.

Concept 7: Business Valuation Is a Range Concept 

Business valuation is not an exact science. Various buyers will value each business differently, and the same goes for appraisers. All this goes to say that the value of a business should never be a single hard number, but rather a range of values. 

A Valuation Is Based on a Professional’s Opinion

When obtaining a valuation, you’re paying for a professional’s opinion. This is a subjective point of view from an independent professional and can change based on any new information they obtain. This represents the professional’s opinion as to what a hypothetical buyer is likely to pay for your business, not necessarily what your company will actually sell for in the real marketplace. 

Valuation Is Essentially Mind Reading

In reality, the appraiser is attempting to predict how a diverse audience with different preferences, views, and perspectives will behave. Making this prediction is inherently difficult, which is why the range of possible values for a business is wider than for other investments such as real estate. 

Identifying Value Drivers

A key part of an appraiser’s value is not in giving you a single number but rather in identifying those factors that will heavily influence the value of your business. For example, your business may have a strong management team or valuable lineup of proprietary recipes. These factors are called value drivers. Knowing what these factors are will help you maximize your business’s value.

Concept 8: Transaction Structure Affects Value

In most transactions, some portion of the purchase price is contingent. It follows that the terms of the sale – such as the amount of the down payment, repayment period, and interest rate – can all affect how much a buyer will be willing to pay. Regardless of the terms, you should walk away from any transaction if the cash you receive at closing doesn’t meet the minimum you’re willing to accept for your business.

Concept 9: Your Personal Needs Affect Value

Poor health or financial pressures may force you to sell. If, for these or other understandable reasons, you need to sell quickly, you’ll probably have to accept less than the optimal sale price. Similarly, if you’re unable or unwilling to work for the buyer, even for a short time after the closing, that fact may diminish the value of the business in the buyer’s eyes. Many buyers prefer to have you stay on board during the entire transition period.

Conclusion

Valuing a business is a challenging task, even for the most seasoned advisor. Unless you’ve got a crystal ball, the best you can hope to do is to make an educated guess about what the future will bring while trying to stay unbiased. Although such an assessment of value may be tenuous, it’s nonetheless the starting point of the M&A process and a critical component of a successful exit strategy for any entrepreneur. A valuation of your business serves as a baseline from which to develop your exit strategy – the ultimate value can only be determined through a carefully executed sale.