Most owners have an idea what they think their business is worth, even if they aren’t planning on selling it. Because small business owners are an extremely diverse group in terms of their thought processes, they arrive at their valuation numbers using a variety of different methods. Seeking professional insight may be helpful, or it may confuse the process even further. Why? Because there are no absolute rules on valuing a small business, and implicit in any valuation process are a set of assumptions and variables that are inherently subjective. There is no magic formula. A valuation professional can be every bit as wrong as anyone else. Experts are often wrong, and not only that, they’re wrong much more often, and to a greater degree, than we think.
If you need any further convincing of this fact, consider two recent examples: Uber and WeWork. The brightest Wall Street investment bankers spared no expense in analyzing the values of both companies in order to fight for the right to take them public, and the stakes for being right could not have been higher. Still, valuations for both companies varied wildly - by tens of billions of dollars among the various banks - and when the “best” valuations of both companies were subjected to the public markets, they were exposed as horrendously inaccurate: Uber’s stock price dropped more than forty percent after its debut, and has not yet recovered. WeWork was an even bigger disaster. The assault on the company’s IPO valuation of $47 Billion was so intense that the offering was shelved altogether, the CEO was forced out, and serious questions were raised about SoftBank, WeWork’s largest private investor. Softbank’s investment a few years earlier valued WeWork at $20 Billion. After the IPO flameout, WeWork’s value stood closer to $7 Billion.
The fallibility of experts does not, however, mean that all hope is lost, or that the value you place on your business is destined to be an embarrassingly bad guess that carries its own dangers. You should not be discouraged from wanting to know what your business is worth. On the contrary, knowing its worth, and why, is important - and for more reasons than you may realize. What we should learn from the WeWork and Uber debacles is that valuation methodology, data precision, and all the other trappings of a “professional” valuation are far less important than avoiding mistakes that have nothing to do with math. These are some of the most common:
1. Making Assumptions about Buyers
Setting aside the existential aspects of worth, something is worth what someone else is willing to pay for it. Most of us accept this, but nevertheless fail to start with this question when we value a business.
A transaction requires a ready, willing and able buyer and a ready willing and able seller. The value of an asset that cannot be sold often isn’t zero, but it is always less than if that asset can be sold. This is obvious enough, but what it means in the business valuation context is often overlooked. If you want to sell your business, you need a buyer, and preferably more than one buyer if you want something approximating market value. These buyers don’t just magically appear, and yet we often fail to consider what causes them to appear.
Marketing your business is the most obvious way to create buyers and increase value. Consider: where are the buyers for your business and what will it take to find them and get them interested? For each business and business owner, the answer is different. Your unique answer to this question is critical to understanding your company’s value. It can’t be overlooked. The costs of marketing your business, as well as the time and risk associated with finding a buyer, all reduce its value.
A willing buyer is not necessarily an able buyer. Someone may see the value in your business, but unless they have access to the required amount of capital, you’re nowhere. That means banks or other funding sources must see the value in your business as well. It’s therefore critical to understand how willing banks are to loan money to buyers in your particular industry, and on what terms.
It is the rare business owner that has seriously considered these issues. While they are intuitively important, it’s understandable why they’re nevertheless overlooked; they have nothing much to do with day to day business. However, if you don’t understand who can buy your business and how they’re going to pay for it, it’s unlikely you’ll reach a reasonable valuation.
2. Waiting Until It’s Time to Sell to Think About Value
It’s exceedingly common for business owners to wait until they’re ready to sell before considering what their business is worth. Worse yet, many wait until they have an offer. There are a few reasons this is a mistake.
First, understanding the value of your business and how it changes over time ought to be a key metric in measuring your company’s performance. Most successful executives of companies large and small monitor key business metrics on a regular basis, some on a daily basis.
Second, thinking about the value of your business, and what characteristics increase and decrease that value, will inform better long-term decision-making. If you want your business to be worth, say, $5 Million when you retire in ten years, the first question ought to be: What is it worth now? And the second question ought to be: Why?
Attorneys and law firms provide an excellent example. A hypothetical attorney, let’s call her “Anne,” earns $100,000 per year as a solo practitioner. Anne has the opportunity to join a law firm as one of five equity partners, where she expects to earn the same $100,000 per year. Should she be indifferent to the opportunity? Of course not - when she decides to retire, she will now own an asset (equity in the law firm) that can be sold to another aspiring partner. The firm will most likely continue on without her, but as a solo practitioner her practice would be nearly worthless at retirement without her. All other things being equal, she is far better off joining the law firm. If she merely considers the income her business provides her, and not the value of the business itself, she will miss the opportunity.
Many business owners make some variation of this mistake. Often small businesses that center on the owner and their individual efforts generate high returns, and owners have a difficult time seeing the value in expanding the business. This is especially true if expansion will reduce profit margins. In a singular mission to increase margins, owners often miss opportunities throughout the life of their business that would dramatically increase value.
There are two distinct ways business owners typically take their own efforts for granted and greatly underestimate their personal importance to their company’s success. First, modesty is generally considered an admirable trait, and one most professionals aspire to maintain. Second, we tend to forget just how much we’ve come to know about our areas of expertise over time, and project our knowledge onto others. We all reinforce both of these concepts when we say things like, “I was just in the right place at the right time.” This type of thinking can be downright dangerous when valuing a small business.
3. Taking Yourself for Granted
An owner that undervalues their individual expertise, knowledge, connections and experience will inevitably overvalue other factors in explaining the value and success of their business. The problem with this approach is that the value of the owner’s unique contributions are not being sold with the business. Downplaying their own importance will cause an owner to overestimate the value of the business itself.
Landscaping businesses offer an illustrative example. An owner of a successful landscaping business may not consider themselves all that important to the business because they have dozens of employees along with large investments in vehicles and equipment. The landscaping business does not have educational barriers for admission (like, for instance, a medical practice) nor does it obviously require talent. Intuitively, this may push many toward the conclusion that the business “runs itself,” and therefore derives its value separate from its owner. That is an entirely unfounded assumption. The value of the business is still extremely owner-dependent - on the owner’s skill, experience, and accumulated knowledge rather than any specific “gift”. This skill, experience and knowledge is spread over a variety of disciplines from salesmanship, accurately estimating job costs and the evaluation of employee performance, just to name a few.
In many ways, this can be the most dangerous mistake of all, because it is so insidious. As we watch CNBC and similar fare, and the talking heads discuss valuations of publicly traded companies, we tend to associate the metrics used with our own our own businesses. When the commentators turn out to be right about those publicly traded businesses, this only reinforces our sense that we are learning something valuable from them. Usually, we aren’t.
4. Watching too much TV
It is common, for instance, for small business owners to think (and speak) about the value of their business in terms of earnings multiples. While it may not be a completely useless framework for considering small business value, it certainly can’t be used in the same manner it is used with public companies.
To understand how dangerous earnings multiples, or P/E ratios (the inverse expression of the same concept) can be to valuing your business, it may be useful to challenge your assumptions about them. Let’s start with a simple question - do stock prices reflecting a higher earnings multiple suggest the market is overvalued or undervalued?
Most of us will intuitively think that a higher multiple suggests overvaluation. It suggests an irrational belief that a) a company’s earnings are expected to increase over time, and b) there is little risk to the company’s present earnings. So, when the market is at its point of the most irrational exuberance, it will be characterized by the highest P/E ratios, right?
The highest P/E ratio for the Fortune 500 (123.73) occurred in May 2009, when the economy was in the grips of the most dramatic crisis of our lifetime. The lowest ratio was recorded in December, 1917 (5.31), a year before the end of World War I. If those two data points leave you scratching your head a bit, that’s a good thing. P/E ratios, especially in publicly traded markets, are a complex expression of a consensus belief about the ability of companies to grow their present earnings and manage earnings risk. They can be widely variable depending on the economic environment but, more importantly, the individual circumstances of each company. The fact that Microsoft trades at twenty times earnings tells you absolutely nothing about your business’ value. A valuation that represents a high earnings multiple isn’t necessarily based on blind optimism (was anyone optimistic in May 2009?), and a low multiple valuation likewise doesn’t necessarily take a dim view of a company’s prospects.
Nowhere is this more true than in valuing a small business, a situation in which the micro facts and trends are far more important than the macroeconomic outlook. At most, an earnings multiple can serve as a red flag for issues meriting further investigation. For instance, a laundromat you are targeting for purchase is offered for sale at $250,000. Its earnings for the prior 12-month period, however, were only $5,000, leading to an earnings multiple of 50. Does this mean the price is too high? Of course not. It merely leads us to ask the obvious question: why did the company only earn $5,000 last year? The answer to that question will likely teach us a lot about the risks of the business, as well as its future prospects, but the number itself tells us nothing.
Another pitfall of consuming too much financial programming is a basic overvaluation of macroeconomic conditions. For instance, if the national economy is experiencing a mild recession, or period of solid growth, there is a tendency to let that situation color our thinking in unrealistic ways. Most businesses, especially small businesses, are driven by unique factors and not macroeconomic conditions. The likelihood the value of your business is affected in any significant way by national GDP are extremely low.
Almost everyone that offers advice on valuing small businesses begins with the premise that “book value,” the value of the individual assets that comprise your business if they were sold separately, is the “minimum” value of a business, and the absolute least a business can ever be worth. In other words, using book value as a basis for establishing your company’s value is akin to admitting the business, what you’ve worked for years to build, has no value. Starting with book value is, therefore, an admission of defeat, and that you are a failure as a small business owner if your business is worth at or near book value.
5. Running Away from Book Value
This is simply untrue. First of all, most small businesses are worth only fractions more than their book value. When we think about it for a moment, this should neither be surprising nor depressing. After all, what else would their value be based upon?
This is a bit clearer when you consider things from the perspective of the buyer. If they’re smart, they typically start with the book value of the business, and then consider what they’re buying that they can’t conveniently purchase somewhere else. In other words, why do they need to buy a business rather than simply buy the same component parts on the open market (vehicles, equipment, etc.) and compete with the target business? Often, there are no good reasons, which is why the value of many small businesses is close to book value. Other than the convenience of finding all of the necessary ingredients for starting a business in one convenient place, there isn’t value to them. Sure, the existing business has a track record of financial performance but that was under previous management, and only has limited utility when looking toward the future.
The relentless desire to escape book value leads many a small business owner to convince themselves that their business indeed has something special going for it, such as a unique brand, a great location, repeat customers, trade secrets or something of the sort that should collectively be considered “goodwill.” These things do exist, to be sure, but it is much easier to overvalue them than to undervalue them, and if they increase the value of a small business by more than ten percent over its book value, they should be heavily scrutinized.
When you’re operating a business day-to-day, you almost certainly dedicate some amount of time to watching your competitors. That may be the rival restaurant down the street, an online competitor, or someone selling a new, substitutable product. When you’re selling your business, however, the competition isn’t the other guy down the street or online. The competition comes primarily from two places: the job market and the open market for the component parts for your business.
6. Failing to Recognize the Real Competition
Many small business owners take for granted that owning a business is a far superior life choice to working for someone else as an employee, but on the margins people choose between the two every day. The willingness of a prospective buyer to pay your asking price can depend as much on the health of the job market as it does on the health of your business and its fundamentals. For instance, In-N-Out Burger pays its managers $160,000 per year. At what price could a local, family-owned burger joint that generates $100,000 per year in income be competitive with a job offer from In-N-Out Burger for 60% more? It’s hard to say for sure, but this certainly puts downward pressure on the price of the local mom and pop, and lots of it.
Likewise, if the component parts of your business are easily identified, located, and available at low prices, it’s likely that any buyer will be weighing the option of buying those pieces individually rather than together in the form of your business. If those component parts are in oversupply, it becomes even more difficult to get much of a premium over book value.
There is a tendency to associate continuity with value, especially in small business valuation, but careful observers realize one has little to do with the other. A business that has been steadily profitable for twenty years, for instance, may appear more attractive than a start-up business, or at least more stable, but appearances can be deceiving. Businesses often face existential threats from completely unforeseen directions, many of which do not discriminate between new and old businesses, but between those that adapt and those that do not.
7. Thinking Yesterday is Tomorrow
The taxi business offers a great example. In 2000, nothing about the taxi business suggested disaster on the horizon; there was a steady growth in demand and profits, and to make the situation even more attractive for investors, market entry by new competitors was heavily regulated (and therefore discouraged) in nearly every U.S. market. And yet disaster did strike, first in the form of an entirely unpredictable terrorist attack on September 11, 2001, which damaged the industry in unexpected ways, and later in the form of the smartphone, which enabled two companies, Uber and Lyft, to redefine the market and render taxi companies nearly irrelevant, both politically and in the market. What was perhaps even more unpredictable was both Uber and Lyft did so without even turning a profit!
Previous stability and past performance is, therefore, more value illusion than reality. And yet, most business owners rely heavily on the history of their business to inform its present value. They can’t help but appreciate the wealth it has brought them and their family, and associate this with its value moving forward. What history really teaches us, however, is that continued indefinite success is the narrow exception, not the rule.
The most common and significant errors business owners make when estimating the value of their businesses aren’t math errors, nor are they due to applying amateurish techniques in the place of an exhaustive formal appraisal by a professional. In fact, they are precisely the same mistakes many professionals will make in valuing a business: starting with flawed assumptions, and failing to think critically about the most fundamental questions, which can be summed up with the following questions: Who is my buyer, and what are they willing and able to pay for my business, given their other options to earn a living? Thinking seriously about these issues may push your valuation lower, but it will almost certainly be a more realistic value as a result. Reliance on better numbers can only help you plan for the future and increase your chances of success running, and selling, the business.