A business owner hires a financial planner to help him with his retirement options. They review the owner’s current assets, his house, stock portfolio and other investments. They go over his insurance coverage. Then the planner asks, “What about your company? How much is that worth?”
The owner replies with confidence, “Oh about five million dollars. Maybe a little bit more.” The planner dutifully adds it to the asset list, and includes it in his calculations. In years of questioning financial planners about this, I’ve found that about 80% accept the owner’s estimate of the value as fact. They assume that the owner must have a pretty good idea of what his largest asset is worth. It is his business, after all.
But what if the owner is wrong? Not only wrong, but completely deluded about the value of his company? Then the planner is basing all his assumptions about retirement, family security, and future income based on assumptions that may be 50% or more off from reality. It happens far more often than you may think.
An owner runs into a long-time colleague at a trade show. In reply to the “What’s new?” question his friend says “Well, I just sold my company. I got $4,000,000.” The owner knows that his company is about 25% larger than his friend’s, so $5,000,000 must clearly be his market value.
Any seller will always claim the highest number he can justify. After a lifetime of building a business, our egos are heavily invested in the bragging rights. The pleasure lies in telling the number, not presenting the details. So that $4,000,000 includes assumption of the company’s $700,000 working capital line, purchase of $1,000,000 in accounts receivable (which were collectable by the seller anyway), and payout of $500,000 in loans that the owner made to his company with post-tax dollars. Of the remaining $1,800,000, some may be conditional on future company performance, tied to continuing employment, in the form of an installment note, or in restricted stock.
Yet our business owner confidently walks away knowing that his company is worth $5,000,000. It must be accurate, since his friend wouldn’t lie and that selling price was determined in an arms-length transaction. Our owner begins planning his future around the day he receives a check for $5,000,000.
In my work with hundreds of business owners, this is a more frequent scenario than not. We have a deep-seated need to believe that our years of sacrifice and hard work are going to pay off handsomely.
Valuation, like most financial benchmarking, is an uncertain art. The professional small business appraisers whom I work with consider assets and cash flow, but also use future industry prospects, local or regional economic trends, the company’s historical revenue and profit variability in developing their opinions.
They usually don’t factor in the financial markets, but those are the most critical influencers of all. Whether lenders are seeking to finance business acquisitions (2006-2007) or avoiding them as if they were the Black Plague (2009-2011) can dramatically affect selling prices.
The buyer is also a determining factor, and not just for credit-worthiness or price negotiation. Individual buyers, competitors, private equity groups and publicly traded companies all have differing ideas of where the value is in an acquisition. They pay a wide range of multiples, and even calculate those multiples on different financial benchmarks.
How much is your company really worth? We’ll go deeper into that next week.
My new book, Hunting in a Farmer’s World, Celebrating the Mind of an Entrepreneur, is now available in paperback and hardcover on Amazon. (Kindle next week.) It is an ownership book, not a management book, and is illustrated with the stories of real entrepreneurs who faced challenges that apply to us all.