A large percentage of business owners think they know the value of their business. Most of them are wrong.
Charlie runs into a colleague at a trade show. In reply to the "What's new?" question, his friend says "Well, I just sold my company. I got $4,000,000." Charlie knows that his company is about 25% larger than his friend's, so $5,000,000 is probably a good estimate of his company’s market value.
A few weeks later, Charlie is working with a financial planner to calculate his retirement needs. They review Charlie’s assets; his stock portfolio, house, 401K and some rent properties. Then the financial advisor asks “How about the business? What is your company worth?”
“I’m confident that I could sell it for right around five million dollars.” Charlie replies. The planner adds the post-tax proceeds of a sale to his assumptions.
In years of questioning financial planners about this, I've found that most accept the owner's estimate of business value as fact. They assume that the owner must have a pretty good idea of what his largest asset is worth. It is his business, after all.
There is one problem. The owner could be dead wrong. Charlie’s friend proudly announced a $4,000,000 sale. He didn’t mention that $1,000,000 was for his accounts receivable (which were his anyway), or that he needed $700,000 of the price to retire his credit line. Another $300,000 will be paid over a two-year employment period, and $500,000 more was conditional on reaching sales goals during those two years.
Of course, any owner uses the highest number he or she can justify when discussing the selling price of a business. It’s a matter of pride. The friend’s pre-tax proceeds at close were closer to $2,500,000 (of which $1,000,000 was his money already.) Charlie’s estimated value for his own business could easily be overestimated by $2,000,000 or more. That would change the retirement plan dramatically.
Valuation, like most financial benchmarking, is as much an art as science. Professional business appraisers consider assets and cash flow, but also use industry metrics, local or regional economic factors, the company's historical revenue curve, and profit trends in developing their opinions.
Appraisers usually don't factor in the financing market, but that may be the biggest influence of all. Whether lenders are enthusiastically backing any business acquisition (2006-2007) or avoiding them like the plague (2009-2011), can dramatically affect your selling price.
As business owners, we have a deep-seated need to believe that our years of sacrifice and hard work are going to pay off handsomely. We’ve also learned that wanting something to happen and making it happen are two very different things.
Understanding the value of your largest single asset, your business, shouldn’t depend on guesswork or hearsay. It requires that you understand how companies are priced in your industry, and the factors that drive higher valuations.
You also should understand the type of buyer who is likely to be attracted by your business. We'll go deeper into that in my next article.