Top 5 Business Valuation Myths

Myth I: Valuing a private business should only be done when the business is ready to be sold or a lender requires a valuation as part of its due diligence process.

Fact I: Although the business sales and lending processes generally require that valuations be completed, if these events represent the first time an owner has a valuation completed, then you can be sure critical business and estate planning issues have not been addressed. If the business is to have a life beyond its current owners, then effective planning for ownership transition requires a regular valuation of the business.

Ownership transition may include gifting some percentage of ownership shares to family members during the owner’s life, thus reducing any tax on the owner’s estate at death. If a firm has several owners, a buy-sell agreement with accompanying life insurance should be in place so that if an owner dies, the remaining owners have sufficient funds to purchaser the decreased owner’s interest at an agreed upon value. The buy-out value under these agreements should be updated regularly to reflect the firm’s financial progress over time and the valuation approach used should be one of several acceptable to the IRS.

Myth II: Business in my industry always sell for two times annual revenue (the revenue multiple). So why should I pay someone to value my business?

Fact II: The short answer is that data on selling prices indicate that revenue multiples within an industry are generally all over the lot. These rules of thumb by business brokers, the individuals who often facilitate private business transactions, are median multiple values. The median value indicates that half of the revenue multiples are below the median value and half are above. Thus, the median value is just a convenient midpoint and does not represent the revenue multiple for any actual transaction. Unless the firm that is being valued is truly a median firm, then using the industry rule of thumb for this purpose is clearly wrong.

For example, according to a well-known source for business transaction data, Pratt’s Stats, recent revenue multiples for firms in the auto parts industry ranged from a low of .98 to a high of 8.3 with a median of 2.9. If you were valuing your firm for sale and your annual revenue was $1 million, then the value of your business could be as low as $980,000, as high as $8.3 million, or somewhere in between. Where your firm lies along this continuum is obviously of the utmost importance and can only be determined by a valuation approach that incorporates academically validated methods with industry-specific valuation factors. Myth IV below discusses the legal and tax implications of assigning a value to your firm that is outside a permissible range.

Myth III: A local competitor sold his business for three times revenue six moth ago. My business is worth at least this much!

Fact III: Maybe yes and maybe no. What happened six months ago is not really relevant to what something is worth today. What your business is worth depends on three factors: I. How much cash it generates today; II. Expected growth in cash in the foreseeable future; and III. The return buyers require on their investment in your business. First of all, unless buyers require on their investment in your business. First of all, unless your firm’s cash flows and growth prospects are very similar to the competitor firm, that firm’s revenue multiple is irrelevant to valuing your firm.

To be continued…