How to Close the Valuation Gap

According to IBISWorld, 98% of business owners do not know the value of their business or have an unrealistic idea of the value of their business.[1]  Business owners who have unrealistic expectations about the value of their business can experience a ‘valuation gap’ - the difference between the fair market value of a company and the business owner’s value expectations. The number one reason a company does not sell is due this valuation gap. 

(Interested in learning how the market values your business and gaining actionable insights to improve your business' performance?  Read about PCE's Diagnostic Valuation tool.)

Valuation Gap Influencers

There are several factors that can influence a business owner’s perception of value.  The most common include:

Rumors of a competitor’s sale price - One of the most common scenarios for business owners to is to base their value on a competitor’s sale. Rumors among privately owned businesses can be very misleading. Sellers may overstate their ending valuation out of pride, or numbers can change as the information is passed from one person to the next. Additionally, outside of the buyer and seller, not many people, if any, know all the facts related to the selling business, including size, profitability, industry mix, management depth, intellectual property, proprietary capabilities and customers. Without this information, making a direct comparison is difficult and often misleading.

Media hype about a large acquisition - Headlines in the Wall Street Journal often tout the high valuations certain companies receive. While these valuations are attention grabbing, they should not be used to judge the value of a company.  More than likely, these transactions are not an appropriate point of comparison for several reasons.

  • Industry – It is not realistic to compare the transactions of companies in different industries. Valuation multiples and operating metrics can vary from industry to industry leading to a misconception of value.
  • Company Size - A company with over $1.0 billion in revenue will receive a higher multiple than the company with $50 million in revenue in the same industry. Typically, larger companies receive more substantial purchase price multiples.

It should also be noted, occasionally public company multiples are used for private companies without any adjustments. Again, the size of these companies is probably not comparable, and the liquidity of the publicly traded stock provides an increase in value as well.

Emotional Capital - This is the value comprised of all the softer assets an owner has invested in his company: sacrificing weekends and evenings to develop the business instead of enjoying the company of family and friends, going the extra mile to save or develop an account, consistently forging better procedures, always stretching one more hour out of the day and one more day out of the week – the business of creating a business.  While most buyers appreciate this investment, paying more for this emotional capital does not happen.

Valuation without methodology - Occasionally an arbitrary number is chosen when business owners value their company. There is no methodology used in this scenario and the number chosen can skew in either direction. An arbitrarily high number, which is often the norm, sets an unrealistic value that is unlikely to be met and will ultimately lead to opportunities missed.  An arbitrarily low number is periodically, but not often, selected and this also leads to an adverse outcome: leaving money on the table. Business owners usually go through the sale process only once, and not maximizing their value could have financial ramifications in the future.

Desire for a certain income to meet lifestyle demands post sale - The amount of annual cash flow a business owner requires to maintain his or her current lifestyle is often used as a metric to value their business. While it is prudent to understand your retirement requirements, this amount should not be used to determine a companies’ value.

Overcome the Valuation Gap

Working with a team of advisors to help determine the business owner’s financial needs post-sale and the company’s worth is chief to overcoming the valuation gap.  The team should consist of trusted people to carry out the pre-sale planning, transaction process and post-transaction tasks. Ideally, this group will include an investment banker, wealth manager, accountant and attorney. Together, they can provide assistance throughout the decision-making process to ensure the business owner is working towards the correct set of achievable goals.

A skilled wealth advisor will evaluate post-transaction monetary requirements, based on desire and appetite for risk.  Business owners need to consider the type of lifestyle they desire to live post sale, and decide on the purchase of additional capital expenditures such as a boat or second home.

Meeting with Certified Public Accountant (CPA) is prudent to understand the tax implications of selling a business. Knowing what you would receive from the sale and how much is necessary are helpful, but the after-tax proceeds from the sale is essential to complete the equation. This is where the accountant takes the lead. The accountant should evaluate the potential proceeds under different scenarios. The tax consequences of a sale often determine the structure and terms of transaction.  This is a key issue to determine early in the exit planning process. 

An attorney is valuable with pre-sale tax planning to help improve the proceeds from the sale or fund future objectives in a more tax efficient way.  The attorney should take part in the pre-sale due diligence review that would also include the investment banker and accountant. The importance of the pre-sale due diligence review cannot be overstated. Going through the due diligence today, will help avoid issues during the deal process, when it counts. By determining if there are issues and resolving them before the sale, value will be maintained and certainty to close is improved.

An investment banker’s knowledge of M&A trends, multiples, buyers, and value enhancers can help the business owner determine what your company is worth. The investment banker will have access to data to support the understanding of value.  If the company’s value is enough to meet the owner’s needs then the choice is whether or not to move forward. While this is not always an easy selection, it is far simpler than the owner’s requirements surpassing the proceeds the sale of the company can provide. If the proceeds from a sale won’t meet the owner’s needs, then there are some important issues that should be addressed. The owner can:

  1. Lower their post-sale requirements and move forward with the sale of the company
  2. Consider a partial sale or recapitalization
  3. Determine what would improve the valuation and execute this plan. Delaying a sale of a company should take into account economic cycles and industry risks.  

Understanding the value of your business and your retirement needs are critical to a successful exit from your company.  Putting together a team of professionals to assist you through the journey will lessen the risk and provide sound guidance to reaching a successful outcome. 

[1] 2014 IBISWorld report, "Business Valuation Firms in the U.S."    [2] 2017 Private Capital Markets Report – Investment Banker Survey

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