Let’s be honest for a moment. We’re all craving a few fuzzy feel goods and slaps on the back when it comes to highlighting our business efforts. After all, by this point, it’s likely you’ve been running it for quite some time. Living in the daily grind of the entrepreneurial street fight isn’t always glamorous or built on a mountain of accolades. Straight up, it’s a nonstop fight you’ve been entrenched in for the better part of your adult life.
Many entrepreneurs seek validation when it comes to selling their business, walking away with that big payoff they’ve been dreaming about for decades. Daydreams of earning a few cool million to coast through retirement can speckle anyone’s dreams. To figure out how far a business is off from that goal typically leads owners to seeking an independent valuation.
Unfortunately, unless you fit into a small percentage of scenarios, an independent valuation isn’t going to give you the market roadmap and reality based kudos you’ve been seeking.
The Challenge of the Independent Valuation in the Marketplace
I will be the first to admit that independent valuations have their time and place. Unfortunately, that place isn’t on the open market, and the time isn’t when you’re trying to sell. I’ll touch on the proper where and when, but before that let’s touch on the reality of the situation.
Independent valuations fill out a formulaic process to generate a number for a theoretical buyer.
I don’t know if you’ve noticed, but your business isn’t in theoretical land, and a theoretical buyer isn’t going to fund your retirement. You need a real buyer. So let’s break down why their valuation won’t hold up in the marketplace.
First, there is a set formula they are required to use when calculating the value. That inert formula doesn’t necessarily account for strategic value, brand recognition, corporate alliances, customer concentration, and other value drivers that might motivate a buyer. They use three valuation methods, but since most small businesses can’t be compared to publicly traded companies, the values determined are not necessarily what the market would pay.
Secondly, most data on small business sales isn’t public. In short, despite their best efforts to calculate in market values and create comps, they don’t have the information. For example, not one of the private business sales we’ve brokered at Exit Consulting Group is public knowledge. That means the final sales number and financing information is not available for certified valuation experts to calculate into the formula.
Third, the valuation is created with a financial buyer in mind. There are three types of buyers for your business, each of which will put a different value on the business. The financial buyer, also known as the professional buyer, will strategically buy businesses for the least amount of money possible. It’s how their model works. See all three different buyer types and their motives here.
Examples of the Shortcomings
Personally, I’ve seen independent valuations come in both low and high. Over the years, many business owners have come to Exit Consulting Group wanting to sell their business for the number calculated by the valuation.
That rarely happens on the open third party market. Sale price is based upon finding a buyer who is willing to pay for the value it is being offered at. It is not to say that the business numbers do not show that the value should be worth that amount, it means that there is no buyer interested in paying that value. Supply and demand is what determines value and not the price it’s being offered at.
First, take an established manufacturing business valued at $2 million. Sure, the mechanics are in place. The business has been operating for several decades and created a recognizable brand name in the industry.
At face value, the valuation makes sense. Now let’s dive into the specifics. The current owner built the business from scratch and still oversees every aspect of the business. This means no middle management team. While profitable, a single client made up 75% of their business. Additionally, since the owner has had retirement on the horizon, updating equipment fell to the wayside. In the meantime, competitors have been ramping up their technology investment, reducing costs, and creating a more efficient process. If that one client got spooked during the sale, that business would be done.
Needless to say, a $2 million sale price was not happening.
On the other hand, take a business that has established contracts to sell products to five large organizations in the San Diego region. Due to the sales revenue and profit the valuation comes in low.
Now let’s factor in that the contracts are exclusive contracts with five universities within Southern California. Pitch that business to a company currently looking to create relationships with those exact schools to sell their complementary products and you have a completely different equation. That valuation goes out the window as the company aggressively works to lock down the deal.
Cases Where an Independent Valuation Makes Sense
As I mentioned, independent valuations do have their role. It’s just more limited than many business owners think. First, it’s essential to have a third party certified business valuation for a relational sale, aka a family member. The IRS wants independent confirmation on the value to ensure you don’t sell a $5 million company for pennies. Internal sales are often the most frequent user of professional valuation as they are independent and are based upon predetermined facts. Since there is no interest in taking the business to market, the valuation is a tool to be used in discussions about the price.
Another common use is if your business is an ESOP or there is an issuance of shares to the existing shareholders. This too offers consistent and deliberate formulas in determining value. Again, the IRS wants confirmation that the numbers are in the right ballpark. Lastly, is for a partnership breakup, buyout, or change of ownership in some form, such as due to divorce. Typically this is outlined as part of the buy–sell agreement.
If you’re curious what your business is actually worth in the real market, or looking for strategic ways to drive value and up that amount, contact us today. We work with businesses to design and implement the most profitable goal-driven exit possible.