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Valuation Math Can Lead You Astray

I met Ryan (not his real name) about six years ago. He told me then he wanted to sell his manufacturing business in two years when he turned 50. But his company was not likely to generate appreciable exit value. Though driving annual revenue consistently above $10 million, Ryan could never seem to get profit margins above 5%.

Since we first met, Ryan has called me every 12 months or so to check in on what was happening in the market. Unfortunately, he hadn’t been able to move profit margins into double digits, so he hadn’t improved his prospects for a meaningful exit value.

A few weeks ago, Ryan called to say he wanted to sell his company in 2021. “I’ve finally got this where I can sell it for what I need.” He went on to say, “I have prepared a spreadsheet to show you how I am calculating my market value, I’ll send it to you and let’s talk about it.”

Ryan’s spreadsheet was his 2020 income statement and a list of expenses he assumed would not be part of the valuation calculus since they were personal and discretionary, hence not necessary for the continued operation of the business. I had no problem with his math to that point. These adjustments brought his EBITDA to about $1,000,000. We discussed what multiple he could expect; my preliminary observation was 3.25 to 3.75.

So far, so good, but Ryan had more lines on his spreadsheet. He assumed his market valuation would also include the value of his assets (i.e., machinery, inventory, and work in progress) which would add another $1,000,000 to the valuation.

I explained to Ryan that asset value is not additive to an income valuation. When a business’ value is based on its income-producing results (i.e., adjusted EBITDA), the valuation assumes the assets used to create that value are included in the valuation. Simply said, if a business can’t generate income without the assets, asset valuation is inclusive, not additive.

Having quarterbacked the buying and selling of businesses for over 25 years, I sometimes forget that even seasoned business owners don’t have a good handle on how their business will be valued. Ryan based his valuation on incorrect assumptions and is now having to reassess his entire strategy. This is why it’s a personal passion to help business owners think through the exit strategy long before they are ready to exit. Good information leads to better decisions, which almost always leads to a better outcome.

 

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. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. https://www.amazon.com/Home-Pros-Guide-Selling-Business/dp/1599329239 .  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. The principles above are true, but the story, names and fact patterns are changed to preserve the parties’ identities.

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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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