03 May Unrealistic Business Valuation Expectations
I love the following quote by Warren Buffett as it sums up my feelings on business value in a nutshell:
Price is what you pay, value is what you get.
One of the biggest struggles with selling in the middle to lower middle market is business valuation expectations. Sellers almost always feel their business is worth far more than what the market will bear. Here are some reasons why this has been the case:
- The owner is valuing assets and not cash-flows. Investors don’t care what you paid for your PP&E even if it has been depreciated in a reasonable matter. In most cases, a buyer is only willing to buy the business based on the cash the company is kicking out month-over-month and quarter-over-quarter. The true value–especially in today’s businesses–is not typically in the hard assets, but said assets are able to produce in a cash-on-cash return for investors.
- One of the biggest problems with valuations is what I might call the Instagram, Whatsapp, OculusVR skew. Just because Facebook paid a multiple outside the range of anything reasonable in the real world, doesn’t mean your company is also worth 100X Revenues or $40/user. In fact, unless the business has some form of intellectual property combined with the ability to scale in a network-based format, forget about it. You’re a traditional business.
- Valuation multiples don’t increase if your bottom-line increases. Sure, the business will be worth more if you put more cash flow to the bottom line, it doesn’t mean your multiple moves from 4x to 6x.
- The owner/operator is reverse-engineering a valuation based on wants/needs, not on fair market value. As I’ve advocated before, there are many instances when selling a business is not the right move at all. If you’re <50 years old, the business is kicking-off cash and you’re looking to retire, but realize you’ll need a 7X or more multiple to get there, forget it. Keep operating the company for a few more years.
There could be a host of other reasons, but these are the most common incident to the clients with whom we’ve recently worked. There are certainly ways to help boost the valuation multiple of the business of up to 40% above the FMV (that’s what our process helps to do), but the exception to the fair value should not be considered the rule. It is tough for sellers and buyers to walk in one another’s shoes. Unfortunately for the seller, the buyer is also usually right about what the value of the business truly is. Because buyers typically acquire businesses many times and sellers only sell maybe once or twice, it usually means the buyer is much more sophisticated and knows more about what the market will bear in terms of price. Hence, as an advisor, it’s always frustrating when sellers fail to listen to both retained advisory and acquiring firms when they tell them their business isn’t worth 12x EBITDA.
A Note on Earnouts
Some owners are diabolically opposed to earnouts as part of the deal structure. Earnouts can increase the risk of not getting paid what is expected and can ultimately be a source of frustration, but in some instances they work really well. In the case when an owner has an unrealistic valuation expectation on the business an earnout may be just the thing to keep expectations in check and provide the right incentives to maintain, manage and grow the business post-acquisition. Earnouts of up to 30% of the total deal value are often applied in situations where the seller wants more and is confident the coming 12, 18 to 24 months will see a boost in the bottom-line.
When it comes time for owners to prepare to sell, the company will certainly sell much faster if management has keen and realistic expectations on what the company is worth. From our experience, the larger the deal gets, the less this particular problem becomes an issue. That’s a topic for another day.