All business owners speculate about the value of their companies. But like most compelling questions, the easy answers are typically not the worthwhile ones. The many myths in the world of business valuation can misguide business owners.
Imagine John, Joanna and Sam discussing the values of their businesses at a networking event for owners of closely-held companies. John says, “we are fortunate to have had a record year after a few down years. That record year will truly drive up the value of my business.” Joanna explains that she, too, believes that her business is worth quite a bit because they have a well-respected Fortune 100 client as their biggest client, one that makes up 85% of their revenues. Sam joins the conversation stating that he already knows what his business is worth: “Barron’s reported that a publicly traded company in my industry sold at 15 times EBITA. All I have to do to figure out the value of my business is calculate 15 times EBITA.”
Unfortunately, all three business owners are buying into business valuation myths that could lead them toward unfavorable decisions. Following are the top myths, including those that John, Joanna and Sam believe, that lead many business owners astray.
MYTH: My financial statements are not complicated, and industry multiples are readily available. My business value should be easily derived as a multiple of EBITDA.
While the earnings stream in the income statement is a determinant of value, this result alone will most often require adjustment and normalization to provide a good indication of enterprise value.
- There are many decision points and judgments within a calculation of value. The results between valuators and users can vary significantly. The foundation of the valuation calculation begins with a determination of the “standard of value” followed by a determination of the appropriate premise of value, identification of the most appropriate approach and then the valuation method. Each step includes different twists and turns in an effort to evaluate the expected returns of an enterprise and the special risks associated with the expected returns.
- The identification of the expected earnings stream attempts to determine the expectation for future earnings. When past earnings are used to determine future earnings, we usually need to go through a process of “normalization” which attempts to adjust income and expenses to reflect those expectations of a market buyer for future operations. Common normalization adjustments include but are not limited to excess officer compensation and benefits, fair market rents on buildings, non-operating assets, unrecorded liabilities and the restatement of depreciation or the fair market value of asset holdings.
- Once normalized earnings expectation is identified, the risks inherent in both the company and its environment are evaluated to ensure that the normalized earnings are achievable. These risks usually vary significantly by company and marketplace, and commonly used multiples or rules of thumb cannot be relied upon to provide adequate consideration of risks.
Every valuation, every business and every industry is unique. While industry similarity and industry rules of thumb may indicate value trends, they typically are not adequate to determine the value of an enterprise. Other factors, including customer base, continued patronage, capital structure, growth expectations, intellectual property advances, existed and continued management, must be considered in evaluation of the earnings stream and a conclusion of value.
MYTH: I just had a huge year with record earnings! This will definitely increase the value of my company.
A buyer of a business considers expected future earnings stream when deciding if they should buy the business and the appropriate price. Historical or past earnings provide an indication of future earnings, but one isolated year is usually not enough to base these expectations. Valuators often consider three to five years of historical earnings or five to ten years of forecast earnings to identify future earnings and growth expectations. Often valuators weigh the historical earnings results with a greater weight being assigned to the most current results as they are perceived to be more reliable indicators of future results. Steady earnings growth is more predictable and therefore more comforting to a buyer than one record year.
MYTH: The strong relationships I’ve created with my clients, vendors and employees add value to my business.
While the strong relationships generally do add value, such relationships must be transferable to add value to the business in the hands of a buyer or successor. The transferability of these relationships is generally enhanced when there are strong and well-documented policies and procedures, ongoing employees and management, and visible connections in customer services, sales and management personnel extending beyond the outgoing ownership. Sole dependence on the owner can diminish the value of a business because the business may seem less likely to function, succeed and grow in the absence of the existing owner.
MYTH: We have been the leading supplier of our Fortune 100 customer for many years. They make up 85% of our revenues and provide us much higher margins than the industry as a whole. Our value expectations are likely to continue to lead the industry.
High concentrations in either customer relationships or vendor relationships can significantly increase the risks to a company and its earnings expectations. This is particularly true when the strength of the relationship partner allows them to dictate terms, pricing and production requirements as a result of changes in the operating environment, raw material shortages or management changes. Diversification in customer and vendor relationships can provide a significant hedge against company risks and add to the predictability of future earnings.
MYTH: Waiting to get the business valued until just prior to sale will provide a more reliable price.
While valuations are often conducted in preparation for transactions, businesses are also valued for litigation, disputes, tax compliance, estate transfers and financing requirements. It can also provide a valuable tool for a company’s strategic planning efforts in evaluating their business model, investment requirements, succession and development opportunities. Consider getting a valuation prior to the event in order to digest the results, determine what steps may enhance the value and address any impediments to a smooth and orderly transition (click here to learn more).
Determining the value of a business involves understanding the purpose of the valuation, the parties involved, the industry and more factors unique to each company and industry. With the help of a business valuation professional, John will learn that he needs to sustain those record earnings and display a predicable stream of earnings to increase the value of his business. Joanna will discover that diversification is more appealing to a buyer than the risk of one big client. And Sam will find out that the differences between his company and the publicly traded company have a significant impact on the valuation. To find out more about determining the value of your business, contact us today.