Debunking Common Misconceptions in Business Valuation
Conducting a business valuation and market assessment are critical steps in determining the value of a company. Business owners, investors, and advisors must understand the value of a business for a variety of reasons. These include a potential sale, taking on investors, estate and tax planning, giving equity compensation to employees, and other strategic reasons.
When it comes to business valuation, many common misconceptions can lead to poor decisions and inaccurate information. This blog seeks to address and clarify several of these misconceptions.
Misconception #1: Valuation is Based on Multiples of Revenue, EBITDA or SDE
One of the most prevalent misunderstandings is that businesses are valued based on multiples of Revenue, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), or SDE (Seller's Discretionary Earnings). These approaches overlook the importance of Free Cash Flow, which is ultimately the critical metric for all business valuation. Free Cash Flow accounts for all expenses and costs including, cost of goods sold, capital expenses, taxes, and an owner’s salary. Free Cash Flow provides the ultimate measure of the business’s financial health and all valuations must ultimately be based on this.
Misconception #2: Future Growth Potential
In the words of Jim Morrison of the Doors, “The future is uncertain and the end is always near.”
The future performance and growth of a business is always uncertain. While contracted and recurring revenue may be more predictable and warrant a higher relative valuation, even that is not guaranteed as we found out with Covid-19.
Investors, lenders, and buyers base their valuation decisions on proven historic and current financial performance. While projections can be made based on current and historic trend lines, any future growth has to be “discounted” back for the risk that it may not be realized.
It is important to note that when selling a business, the future performance and risk of running the business will be under the control and responsibility of the new owner, so they rightfully will expect to get credit and the returns for much of the future growth.
Misconception #3: Expecting an Industry Average Valuation
Expecting to receive a valuation that matches the industry average is misleading. Business valuations vary greatly within the same industry due to factors such as customer diversity, risk levels, operational efficiencies, and many other variables. Every business is unique, and its valuation must reflect its specific circumstances and risks.
The average men’s shoe size in the United States may be a size 10.5, but this only means that half are smaller and half are bigger! The same is true for an Average Business Valuation.
Misconception #4: Asset Sales vs. Stock Sale
Many business owners believe they will sell their company’s stock, thereby avoiding certain taxes, and loan payoffs and will pass all liabilities onto the buyer. However, most small business transactions are asset sales (over 90% of small business sales). This distinction has significant implications for financial planning, taxes, and the handling of potential liabilities. Understanding the implications of an asset vs. stock sale and how they can impact valuation and a business sale are critical.
Misconception #5: Adjusting Cash Flow for Tax Purposes
Owners of privately held companies rightfully want to reduce the amount of reported income to minimize taxes believing they can then simply “adjust” or “addback” many expenses to their cash flow for valuation purposes. However, lenders and investors will rely on tax returns to substantiate cash flow and may not allow for this, thus substantially lowering the value. Underreporting income can not only lead to a lower valuation but also damage credibility with potential buyers and lenders and risk penalties and interest if they are disallowed by the IRS.
It is always worth noting that many acquisitions are funded by government-guaranteed Small Business Loans (SBA loans). These loans are backed by the US government and will always use official tax returns as the basis for cash flow.
Additional Misconceptions
We have compiled a list of additional misconceptions that include the belief in a one-size-fits-all when it comes to valuation methods, the stability of valuations over time, the equation that valuation is equal to the sum of assets like machinery, trucks, equipment etc. plus the value of the business, the idea that more assets equate to a higher valuation, the assumption that similar sales and revenue across companies result in similar valuations, and the reliance on industry-standard multiples for a quick valuation estimate. These misconceptions are addressed in our comprehensive (free) E-Book, that highlight the complexity and variability of business valuation processes.
Conclusion
Understanding the nuances of business valuation is crucial to accurately valuing a business and making informed business decisions. Misconceptions can lead to significant errors in valuation, affecting sales, purchases and strategic planning. Our free E-Book, "Business Valuation Misconceptions," offers a deeper dive into these topics, providing valuable insights for business owners, investors, and advisors. To gain a thorough understanding of business valuation and avoid common pitfalls, download our E-Book today.
