One of the leading causes of M&A deaths is misaligned valuation expectations. Fair value, or the price that a business can be sold to a knowledgeable third party, can often display as two drastically different numbers based on which side of the table you’re sitting on.
Knowledge is power in valuation negotiations, and knowing what to avoid is key in achieving a successful outcome. Below is a list of common valuation misconceptions:
Businesses are valued on multiples of EBIDTA.
This is a common misconception. Businesses are valued on Free Cash Flow discounted for the risk of the business. Many business sellers and brokers who do not understand business valuation often mistakenly say the business is valued based on an industry standard multiple of EBIDTA or even SDE (Sellers Discretionary Earnings).
The only number that matters when it comes to business valuation and financing a business is Free Cash Flow. Free Cash Flow is the cash that is available after paying taxes, capital expenses and a salary to the owner. While it is true that depreciation is added back to cash flow, large depreciation write-offs are typically an indication that there are significant capital expenses that will come up either sooner or later to replace assets that will wear out. These capital expenses impact Free Cash Flow and must be taken into consideration.
I will get credit for potential future growth in the valuation.
While there are exceptions, a growth rate is typically not included in most small business valuations for the sale of a company. There are several reasons why. First, since a new buyer will be taking over the responsibility and risk of running the business, shouldn’t they get credit for the growth after buying it?
Second – and this involves some theory – a high implied growth rate would mean that even the smallest of businesses would grow exponentially over time to a company worth hundreds of millions of dollars or even more. Since this is not possible, only very limited growth rates are factored in when they are used. Also, most lenders are required to use 3 years of past financials when calculating the cash flow available from the business. They will not give credit for future growth in their valuation calculations.
I should expect to receive the industry average valuation.
No, you most certainly should not. The industry average is just that – an average. That number includes valuations much lower and higher than the average. Each valuation is dependent on a number of factors that vary significantly from company to company, even within the same industry.
For example, if two companies in the same industry have the same amount of Free Cash Flow, but one company has a few customers that account for all the revenue each year and the other one has dozens of customers, there would be much more risk for the one with only a few customers. That company would receive a lower valuation. There are many factors that vary from company to company even in the same industry. These factors are what impacts the final valuation, not industry averages.
Valuations won’t change much over a short time period
Valuations – even those of small privately held companies with no market for the shares – can change at any given minute. Anything that impacts the free cash flow of a business or the risk associated with them will change the value.
As an example, Think about the value of a company at the time they lose their biggest customer, key manager or a new innovative competitive product hits the market. The value of that company will change immediately.
The value of my business is equal to my land and building plus my business
We recently completed a valuation on a business with real estate. Over the years the land value increased to several million dollars. The business had cash flow of several hundred thousand dollars but was not recording any rent expense. When we added back fair market rent, virtually all the profits from the business disappeared. The business in its location had no value because the profits could not cover the cost to buy the real estate and pay the debt payment or rent the real estate at fair market value. The owner was unhappy and insisted that we separate out the value of the land & the business and then add them together. But the only way we could do that would be if he sold the real estate and moved the business. He said, “If I do that, I would have to relocate the business and it wouldn’t be worth much.” Exactly our point! The business was not worth much if moved from the prime location, but if charged the true rental cost to keep it there it was worth very little as well.
The more assets I have in my business the more valuable it is.
This is another very common valuation misconception. Business value is based on a company’s ability to generate cash flow. The assets within the business are just a part of the component that creates cash flow. Lenders, investors, business buyers and entrepreneurs want a return on their investment in the form of debt repayment, dividends or capital gains from the ultimate sale of the business. They do not want to liquidate assets to achieve this.
I know the standard valuation multiple in my industry, so I can just apply that to the Cash Flow to get a ballpark valuation?
Don’t ever forget that companies in the same industry, in the same city with the exact same revenue and income can have a wide range of value. The value of a business should not ever be based by simply comparing it to another company in the industry or by saying this is the “average” in my industry. There are just too many different variables and risks that are unique to each specific company. The “average” is just the central point of a wide range of values.
Our team of business valuation experts can help you if you are looking to value your business. At Sunbelt Central America we have a process in which different valuation methodologies are used and we view businesses from several value perspectives.
Source: Exit Advisors