“Overvaluation” is a common problem when selling a business.

Value Price Puzzle Concept

Many people think “This business owes me $500,000, so it must be worth at least that much, or ” “’I’ve been working on this business for 10 years – so it must be worth a lot of money” – but in reality the business value is really about the cash flow of the business. This news comes as a disappointment to many business owners as they have often put their heart and soul into the business, and often think it’s worth a lot of money.

For most business owners it’s difficult to be impartial about something they’ve created, something which you’ve spent years of hard work building, and something which (to an extent) defines who you are. After all a business is many people’s superannuation fund, and they are relying on the sale of the business to fund their retirement.

Most business owners tend to overvalue their businesses, and unfortunately, some business brokers also overvalue businesses because that’s what the vendor wants to hear, and by doing so they improve their prospects of securing the listing of the business.

The sad truth is that of the many thousands of businesses currently on the market, the majority are set at an extremely optimistic asking price

Derek Burgoyne, Cornerstone Business Agents

Ultimately, a business is only worth the amount that a buyer is willing to pay it.

Misleading

Sometimes, a vendor can get lucky and recoup a selling price which is above the value that accepted methods of business valuation may arrive at. It could be that a buyer has a particular reason for wanting that particular type of business – or location, so to that particular buyer its worth more than it would be to most other buyers. That would be an overpayment in terms of market value, but not an overpayment from the vendor’s point of view.

However, this could mislead other vendors into thinking that price is the benchmark for businesses with comparable profits, similar reputation and similar potential, when in actual fact it is an anomaly.

Some people might look at how much a buyer paid for ‘X’ business to determine the price of another business, not realising the reasoning behind the price paid. This can be a “misleading” way of achieving a business valuation.

Experienced business valuers can provide “example after example” of vendors with an inflated sense of their business’s worth. Here are some of the reasons behind overoptimistic overvaluations of the business owner:

  • This is the price the business owner needs to achieve – to cover loans, pay the agents, banks and other creditors. Many owners feel that if they can’t get a certain price for their business then there is no point in selling it, as they can’t pay off their debts, in which case they’d rather go bankrupt. Some business owners simply want to get their original investment back.
  • A trusted adviser with little experience in business valuation or sales has suggested the price. The less experience and confidence an adviser has in his or her ability to value a business the more likely he or she is to overvalue to please the client.
  • A Business Broker suggests the business value to the business owner as a way of gaining the instruction as a sole selling agent. This enables them to get a large up-front fee and then coming back with lower price offerings to “condition” the seller to accept a lower price.
  • There is a lack of financial information supplied. The business ca only then be valued on indications of turnover and profitability. As most owners usually overestimate their turnover and profitability, the business is usually overvalued – in any case this is a suspect method of valuation.
  • The vendor gets greedy. A number of times vendors have told me that they knew their business wasn’t worth the figure they’d asked, but they thought they’d give it a try anyway. Blind optimism!

Unfortunately many well-meaning advisers talk their clients into believing that the business is worth more than it really is. Often because they don’t want to offend, or they don’t really know what the market is doing. …. And often because they are too embarrassed to admit that they are really not sure of the value – so they err on the high side

Bruce Coudrey, Benchmark Business Sales

Overoptimism

The analogy of selling a house can explain how a buyer’s judgment can be clouded by the vendor’s misplaced optimism: When the vendor has a particularly good business and believes its worth above and beyond its true value, they can hold that view so strongly that the buyers believe the hype. It’s like houses, when people put crazy prices on them and people pay it because they’re scared of getting left behind.

Experienced business broker have been quoted as saying: “I’ve never come across a business owner who has undervalued their business; it’s always overvalued, often quite considerably.”

Ensuring an accurate valuation

So – as a business owner, how do you overcome your natural bias towards over-valuing your business? How do you arrive at a valuation which reflects the market value, both present and potential? How do you decide on a price which you have a realistic chance of realising if you are wanting to sell at some time?

Remember that the business value is really about the cash flow of the business – and the DEMAND for that business. Demand for the location, demand for the industry type.

It is always wise to invite two or three experts to discuss the value the business and to ask each expert for an explanation of how they would calculate the business value. Their explanation should include examples of similar businesses recently sold – or on the market at least – and what adjustments and multipliers have been applied to the net profit to value the goodwill of the business. You should also ask them to comment on current demand for the type of business.

It is also wise to seek advice on how the business value could be increased. What improvements would have to be made to the property?, should the lease be extended?, what financial information should be provided?, etc.

It’s clear that there are certain things that business owners must do to ensure they do certain things to minimise the risk of overvaluation:

  • Appoint the right valuer – ideally someone with experience valuing businesses in your sector
  • Listen to the valuer – he’s objective in a way you simply can’t be, and he’s experienced in valuing and selling businesses
  • Provide the valuer with all financial information requested; be as thorough as possible
  • Remember that the true worth of a business is about the income it will generate for the owner, and the potential for growing that income. It has nothing to do with the number of hours you have invested in building the business, or the money that you owe to the bank, or what you have invested – sentiment doesn’t come into it. We all need to be realistic about the value of our business – optimism can only lead to disappointment.

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