What a small business valuation really is!
As a result of work that was part of a couple of recent engagements I was
reminded about one of the cornerstone conventions for undertaking business valuations.
This convention is extremely important but often overlooked when assessing or considering the contents of a valuation report. The convention is definitely noted somewhere in the report though easily missed as you head straight to the “how much” section of the report. The convention is simply that valuations are only opinions.
Sure the report writer has looked at some hard data (financials), probably some market pricing data and made a series of assumptions.
But the end number they conclude is an opinion, their opinion, of what they think the business is worth. While there can legitimately be very divergent opinions of values on the same business, the key point to take out of this is that you as a buyer or seller (read the party taking the financial risk) need to have your own well researched, informed opinion of the value of your business.
Your opinion of value needs to contemplate two aspects;
1. What is the minimum you will sell for or pay, and
2. Factors that may increase or lower the expected value for the opposing party. This aspect is very dynamic. While there always unique aspects in any deal the variations will come from a number of recurring and very common situational factors e.g. financial distress, health issues etc. You need to keep your eyes and ears open for them.
Having your own informed view is obviously critical because you are looking at either:
1. Spending significant capital by making a decision to buy or invest in a business (and paying too much or offering too little and missing out are both bad economics), or
2. Selling your business and using those funds to boost your personal wealth (to fund retirement) or to acquire another business
Either way large sums of your money will be at risk.
In a recent engagement Kerr Capital acted as advisor for an acquirer on a potential acquisition.We evaluated the target business and recommended a maximum offer price of $600K. The target company thought that $600K was too low and instructed a credible business valuer to prepare a valuation. We anticipated that it would come back higher but were genuinely surprised when it came back at just under $2M (i.e. about 3.33 times higher).
After some analysis of the valuation report we were able to pinpoint where the huge variation came from.
Although we both in the same ballpark on adjusted historical earnings we were on different planets in relation to;
1. The assumptions about where the business might head – they simply assumed the business would turn around its recent poor performance. On the other hand we planned for that happening but only with a significant injection of working capital, large scale staff restructuring and buying power
2. The valuation methodology – they prepared the valuation using a completely different methodology. As the business had poor recent profits they valued on the basis of net realisable assets (i.e. what the owners would theoretically realise by selling off all the assets including goodwill). On the other hand we valued it (and generously) on the basis of what profits we thought we could generate in the future and only after we implemented a raft of operational changes to the business.
Given the same hard financial data it’s a remarkable variation in values. This is not an isolated example. We regularly see variations in values where the high end can be between 2 & 4 times higher than the low end. Overall it illustrates nicely how widely opinions can vary and the potential risks from relying on, sometimes in an unquestioning way, what are simply the opinions of professional advisors.
By developing a deeper understanding of the fundamentals of small business cash flow, basic financial statement analysis, comparative business values and basic return of investment formulas you work more effectively with your professional advisor and better understand their advice and opinions.
Some more specific elements of a valuation report that you need to better understand include;
1. Who prepared the valuation and what was the reason? If it was by a representative of the business seller then it will usually be skewed towards a much higher value
2. When was the valuation done and how indicative is it of current i.e. up to the minute financial performance and of future potential performance?
3. Are the assumptions used commercially realistic, often they can be quite academic and/or so broad as to be unrealistic? What valuation methodology or methodologies did the valuer consider and use? The smaller the business value the more the likelihood that a multiple of earnings approach may not work because the earnings are so marginal
4. Do the recast or adjusted financials used in the report accurately represent what profits the business could make if you took over?
In the end it’s your money and your decision, so you need to own it and be responsible for it.