Why is the Range of Possible Values so Wide for a Business?

Jacob Orosz headshot
by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

Why is the range of possible values so broad for a business?

Valuing a business is an inherently difficult undertaking, but it’s a critical step in planning the sale of your business. The essence of valuing a business is predicting the future cash flows of a business and then placing a value on those cash flows based on their present value.

Such a task is challenging due to the following factors:

  • Limited information. A limited amount of accurate information is available to accurately value small to mid-sized businesses.
    • Information on the business and its industry and comparable transactions is limited, biased, unverifiable, or inaccurate.
    • The value of a business can only be determined once when the business is sold, and information on small business transfers is scarce.
  • Prediction. The value of a business can be impacted by future events and human behavior, which are impossible to predict.
    • Predicting human behavior is futile.
    • Predicting future cash flow in a business is impractical.
    • Predicting the impact of future external factors, such as changes in the economy or industry, is impossible.
  • Buyers. There is a wide universe of potential buyers with diverse criteria.
    • Perceptions of risk vary across a wide group of buyers.
    • Lost opportunity costs vary among buyers, especially for small businesses.
    • The value of synergies is difficult to estimate.
  • Judgment. Biases and conflicts of interest can cloud an advisor’s judgment.
    • Appraisers lack real-world experience in selling companies.
    • The structure of the broker’s compensation may affect their opinion.
    • Appraisers’ unconscious biases cloud their judgment.
  • Time and effort. Properly valuing a business requires significant time and effort, and tools are inadequate.
    • Properly valuing a business takes significant time.
    • Most valuation software is not designed for M&A transactions.

In this article, we explore why valuing a business is inherently difficult, and why the ranges of potential values for a business are much wider than for other assets. After reading this article, you will have a greater understanding of the challenges you may face when valuing your business, and learn what factors can affect the potential range of values.

Limited Information

Information is Limited

There is a limited amount of available information on comparable transactions for the sale of small to mid-sized businesses. Information is readily available on public companies, but there are vast differences between valuing private and public companies. The market for small to mid-sized businesses is inefficient and relevant information is scarce, to say the least.

Even if information from comparable public companies is available, the biases of analysts who prepare equity research reports for public companies must be questioned. If the majority of equity research reports recommend a “buy,” how could they be deemed a dependable source of information, especially if their future compensation is dependent on their conclusions?

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 information. Critical transaction information may be missing from the database, such as the terms provided, how EBITDA was calculated, whether the parties are related, whether the seller was distressed (e.g., dying of cancer), and other relevant information. This makes it difficult to adjust comparable transactions to make them truly comparable.

Not only is information limited or biased, but it can also be incomplete or inaccurate. Analysts must rely on information from ownership or management, which can be biased; or on accounting and financial information, which is often incomplete. The result of this lack of unbiased, complete, and available information is that an analyst’s opinion of value is merely conjecture. It will continue to evolve as they acquire new information, or as their understanding of existing information changes.

Value is Only Determined in a Sale

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

Just because “ABC Corporation” was valued at $100 million does not mean it is worth $100 million until someone actually pays $100 million. Just because your friend’s company was valued at a six multiple does not mean your company is also worth a six multiple because you are both in the same industry and have similar-sized businesses. Just because your uncle received an offer on his business for $10 million, which works out to 70% of revenue, does not mean your business is worth $14 million because it generates $20 million in revenue, or 70% of revenue.

An appraisal or the asking price of a similar business is not a comparable transaction. A comparable transaction must come from an actual transaction, not an appraisal, the asking price from a similar business, or other hypothetical non-transactions. This sort of information is limited for small to mid-sized businesses.

Predicting Human Behavior & the Future is Difficult

Predicting Human Behavior is Difficult

The essence of valuation is predicting how other people will behave (i.e., the price they will actually pay). Predicting human behavior is perhaps one of the most universally challenging problems on the planet. Even the world’s most respected mutual and hedge fund managers, with billion-dollar budgets and thousands of employees on staff, whose sole objective is to predict the future value of publicly traded companies, can’t consistently beat the markets.

In 2007, Warren Buffett bet $1,000,000 that the S&P 500 would outperform a collection of hand-picked hedge funds. Buffett wasn’t betting against the “average” hedge fund. No, 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, however, only one stepped forward and despite their ability to actively monitor the funds with the assistance of hundreds of analysts, their performance was brutally murdered by a passive investment in an index fund that required no work and a staff of exactly zero.

What’s the lesson? The market is impossible to predict, even for those with teams of hundreds of people 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. Even Warren Buffett, considered by many to be the world’s greatest investor of all time, claims he cannot 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 to the dot-com bubble in 1999, human irrational behavior has proved impossible to predict. Predicting the behavior of a single individual is difficult enough, let alone the difficulty of 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 predict.

Estimating Cash Flow is Difficult

The fundamental premise of most methods of valuing a business is placing a value on the cash flows one expects to receive in the future. After all, a buyer is buying future cash flows, not historical cash flows.

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

Not only must future cash flows of a business be predicted, but the potential risk of receiving those cash flows must be assessed as well. Accurately predicting failure is impossible, and the potential for failure must be built into any financial model.

When valuing a business, one must estimate future cash flows as well as their potential for growth and associated risk. Such an estimate is subjective at best, even if 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.

Impact of Future Factors is Unpredictable

Price depends on demand, which itself is dependent on a wide variety of factors, from interest rates, to availability of financing, to unemployment rates (in the case of individual buyers), and manifold other macroeconomic, social (i.e., consumer products), demographic, industry, competitive, and political factors. Future value is dependent on factors beyond our immediate control, and the impact of these factors can’t be predicted.

The economy impacts certain businesses to a great degree, especially those selling a discretionary product or service, or consumer product companies, 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 governmental regulations, and one can only conjecture at their likelihood and potential impact. Our lawmakers wield power to determine the fate of many industries, many of whose motives are questionable, which introduces an additional layer of guesswork for any business operating in such an industry.

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

Wide Universe of Potential Buyers with Diverse Criteria

Perceptions of Risk Vary

The group of potential buyers for a business is diverse, thereby greatly expanding the potential for a diverse range of opinions. For example, a lower mid-market business may have the following potential buyers: wealthy individuals with varied ethnicities or business backgrounds, direct competitors, indirect competitors, financial buyers, and possibly publicly traded companies.

The views, perspectives, expectations, and tolerance for risk amongst this diverse group of buyers can vary greatly, resulting in a wide range of potential values. The tolerance for risk varies widely from buyer to buyer, and 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. Because perceptions of risk vary across buyers, the value of a business is ultimately determined by a buyer’s perception of risk, which cannot be accurately measured. Any valuation, such as the valuation we perform in our Assessment (Step 1 of our process), should first explore the potential universe of buyers and then calculate a range of potential values those buyers may pay.

Lost Opportunity Cost to the Buyer Varies

The value of a small business is highly dependent on the lost opportunity cost of the buyer. Someone with an earning potential of $300,000 per year wouldn’t invest in a small business that required their full-time involvement, and that only earned $200,000 per year, even if it were given to them for free because it would cost them $100,000 per year in lost opportunities ($300,000 – $200,000 = $100,000). On the other hand, some buyers might see tremendous opportunity in a business that has the potential to earn them six figures.

Lost opportunity costs also vary for corporations. The lost opportunity cost of acquisition for any corporate buyer is the cost of not completing another transaction or any other form of corporate development, such as launching a new product, forming a joint venture, or expanding distribution channels. Because the lost opportunity cost varies from buyer to buyer, the value of a small business will 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 anticipate. When selling a middle-market business, the potential universe of buyers normally includes direct or indirect competitors. Oftentimes, competitors bring synergies to the table in the form of 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 $2,000,000 per year is purchased by a competitor that brings an additional $1,000,000 in increased EBITDA in the form of synergies to the table, the valuation could look like this:

  • Before Synergies: $2,000,000 EBITDA x 4.0 multiple = $8,000,000 value
  • After Synergies: $3,000,000 EBITDA x 4.0 multiple = $12,000,000 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. Buyers rarely provide the target access to their financial models, let alone their reasons for the acquisition. As a result, in most cases, a target may not understand the buyer’s true motives for a transaction and will rarely be privy to a buyer’s financial models, projections, or other analyses, which can be used to calculate the amount of the synergies. The best that can be done is to reverse-engineer the buyer’s potential synergies, estimate their value, and then negotiate to the highest purchase price possible, ideally with multiple buyers, in the form of a private auction. A valuation, which is based on synergies, is, at best, an educated guess and normally only serves as a baseline upon which the company may be valued.

Biases & Conflicts of Interest Cloud Judgment

Appraisers Lack Real-World Experience

The air of probity in which most appraisers carry themselves overshadows an important requirement — experience. Most business appraisers have no experience selling companies in the real world, yet, the appraiser’s job is to make an educated guess as to what a buyer will pay for a business. While the majority of appraisals are prepared for tax or legal purposes, those prepared for purposes of selling a business should be prepared by someone with real-world experience in the marketplace, such as an investment banker or M&A advisor.

Broker’s Compensation Clouds Their Judgment

Business brokers and M&A advisors’ form of compensation may affect their opinion. If their opinion is too low or too high, it’s possible a potential client may move elsewhere. An advisor may pad their opinion so as to not lose 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, if possible, and the true beneficiary of any valuation should always be questioned. As an example, our unique fee structure has aligned our interest with business owners and mitigates the impact of conflicts of interest.

Cognitive Biases Cloud 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 biases, which are often subconscious and, therefore, undetectable.

Following is a list of cognitive biases and potential examples that can be manifested when attempting to value a business:

  • Confirmation Bias: The appraiser seeks information to confirm their bias. For example, they may have a long-term belief that the range for multiples for radio stations may be 12-14 times, and they may ignore information that doesn’t support this bias. They may also form an initial opinion in their head 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 are not recent.
  • Anchoring Bias: The appraiser first learns through another appraiser, who is widely considered a leader in the field, that multiples in the aerospace industry are in the range of 6 to 7 times EBITDA. This becomes the “anchor” and the advisor then seeks information to confirm this anchor, ignoring information that conflicts.
  • Availability Bias: The appraiser may place too much emphasis on data that is readily available, and not perform an exhaustive search for information that is less available.
  • Conservatism Bias: The appraiser may cling to their long-held belief that multiples never exceed six if EBITDA is below $5 million, and then consciously ignores information that doesn’t support this personal belief.
  • Contrast Effect: The investment banker may hear of a transaction with a 20 multiple in an industry in which they are valuing a business, so they push up their estimate from a 5.0 multiple to a 6.0 multiple. 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 take efforts to mitigate the impact of their biases on their opinion. Readers of appraisals should also be aware of the potential for biases to be built into any valuation and be aware what impact such biases can have on the appraisal.

Significant Time & Effort Required & Tools are Inadequate

Software is Not Designed for M&A Valuations

Most software to appraise businesses is designed for legal or tax purposes. The methods used in the courtroom are entirely different from those used by buyers in the real world. Most software is inadequate to address 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 is required by the software, despite it not being relevant to the business’ stage of growth or its industry. For example, many appraisal software programs analyze key financial ratios, such as debt to equity ratios. These ratios may be irrelevant for a small tech company in which the transaction is structured as an asset sale.

For owners considering a sale, an M&A advisor’s oral opinion can sometimes be more valuable than a written appraisal. For example, during our Assessment, 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, and then explain our opinion of value in detail during a phone call with the owner. We feel we can best assess and communicate our opinion of value to an owner if we are not encumbered by the built-in limitations of external software. If you are considering paying for a written appraisal, ask for a sample report and be sure that you can understand it and that the information is relevant for your business and industry before you pay for the valuation.

A Significant Amount of Time & Effort Are Required

Properly valuing a business takes a significant amount of time. Time is required to understand and predict future cash flows. The more time that is invested in preparing the appraisal and predicting cash flows, the more accurate those predictions are likely to be. However, most small business owners 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, whose views may be biased.

Secondly, even if sufficient time is spent understanding the business and the industry, how accurately can future cash flow be predicted for a small business? The best one can do is to make an educated guess. A small 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. Larger businesses are less dependent on one individual, making them less vulnerable to the concentration of skills and effort that may be present in smaller businesses.

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

Additional Factors

The M&A Market is Inefficient

Lack of Comparable Transactions

Some markets, such as the real estate market, have a ready supply of highly comparable transactions. The market for businesses, on the other hand, is fragmented, and it’s difficult to obtain relevant comparable transactions.

Values Change Based on Markets

Because the marketplace for the sale of small- and mid-sized businesses is inefficient, values vary wildly. Current market conditions can therefore greatly affect the final selling price of your business.

Terms Affect The Value

The price a buyer will agree to pay is often tied directly to the terms of payment. It would be ideal if you could be paid in one lump sum. In the real world, however, chances are you will be selling your business on an installment basis, in which the buyer pays you over time.

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, the repayment period, and the interest rate — can all affect how much a buyer will be willing to pay.

An installment sale may affect your sale price calculation in another important way:

You may want to charge a higher interest rate if you will be paid over a longer period of time rather than a shorter period of time, since during the repayment period you will be exposed to more risk.

Keep in mind that selling on an installment plan can benefit you because it often puts you into a lower income tax bracket than would apply if you received the entire sale proceeds in one lump sum.

Regardless of the terms, you should walk away from any deal in which the cash you will receive at closing does not meet the minimum you are willing to accept for the business.

Owner’s Personal Needs Affect Value

Poor health or financial pressures may force you to sell. If you need to sell quickly, you will probably have to accept less than the optimal sale price. Similarly, if you are 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 the seller stay on board during the entire transition period.

Summary

Valuing a business is a challenging task for even the most seasoned advisor. The best one can hope to do is to make an educated guess as to the future, which can be based on a limited amount of questionable information. While such an opinion of value may be tenuous at best, it is 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 and the ultimate value can only be determined through a carefully executed sale.