The A of Valuation ABCs

It’s no fun telling a songwriter his song is bad. Telling an author her novel won’t sell takes nerves of steel. Telling a business owner his business is overvalued is no way to make a friend, much less gain a client.

Marvin (not his real name) was flat P-O’ed at me. When I told him how a buyer would look at his business, he told me in no uncertain terms he was not going to hire me because I didn’t know the market and didn’t appreciate how hard he’d worked over the years.

After almost 30 years of buying and selling businesses, I understand that it’s common for a business owner to have an unrealistic valuation expectation. This disconnect can be exacerbated by a business broker who is not honest with the business owner. Too many business brokers will tell an owner what the owner wants to hear about his valuation so as to get the listing, hoping the owner will lower his expectation if an offer comes in.

But here’s the deal, over-priced businesses usually don’t generate quality offers. For me, I take the honest approach and tell my clients in advance what they can reasonably expect to get for their business. Sometimes there is fallout like Marvin, but most times, an owner will recognize and appreciate my honesty.

I see owner expectations out of whack for one of two reasons. First, the business owner decides what he/she NEEDS from the business, and from that attributes his valuation expectation. In other words, they back into their valuation. Marvin said it this way, “Once I pay off my debts, I’d need to have about $2 million to retire.” Given that he had $1.5 million of debt, his expectation required a valuation of $3.5 million. Suffice it to say, when I told him the market valuation was closer to $2 million, I didn’t make a friend.

Faulty logic is the other reason for which I see owner expectations out of whack. This happens when the owner looks at data from incomparable markets/situations and then extrapolates those metrics to their business. Marvin went on to say, “What the h___? The stock market trades for crazy multiples, and you’re telling me my valuation is only three times cash flow? That makes no sense!” I often have to be the one to tell a business that metrics for publicly traded companies don’t apply for most small businesses (the reasons for this would take a book to explain, I will write one someday). Suffice it to say, a multiple on GAAP earnings of a publicly traded company is apples-and-oranges to a multiple on cash flow of a privately-held business.

Every situation is different, and indeed there can be extenuating circumstances that skew the basic principles. But there are a couple general rules that apply to valuation of all privately-held businesses. At the risk of a run-on sentence, here you go: valuation is based on a buyer’s forecast of future cash flow, and that forecast has to be based in reality in the form of historic averages and/or a clear articulation of how to grow the business and the return on investment generated from that growth effort.

I know, I know, that’s a mouth full, but read it carefully and it should make sense. Marvin’s $3.5 million expectation would have been reasonable had his business been growing at a faster rate and/or if he had a clear plan for growth other than “we need more marketing.” It’s a life goal of mine to help as many business owners as possible understand these basic principles of valuation. It will sure save them enormous frustration once it’s time to sell.

 
JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee.

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Tennessee Valley Group

Jim Cumbee established Tennessee Valley Group to help business owners fulfill their dreams for life after business ownership. It’s a mission that his 30+ year career history had prepared him well for—in addition to being an attorney, transition mediator and business broker, Jim has been a buyer, seller, and entrepreneur. His broad range of experience gives him unique insight into how business buyers and sellers can achieve their goals.

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