Business Valuation: Busting Common Myths

valuation

A business is not a static entity. It is a dynamic organization that adapts and changes. Even if the company resists change, the economic environment around it certainly will. Those various changes affect a business’ value.

Business valuation entails more the company’s profit and loss statement or balance sheet. As a business owner, you want to reap the results of your hard work. You understand your products and services and your customers’ needs. You have built a solid customer base. Since you know your business’s financial records, one might assume that you would also have a sound understanding of your business’ value.

However, business valuation is complicated and involves multiple variables, both tangible and intangible. Tangible assets are easy to identify, but identifying intangible assets is more complex. Intangible assets may create a huge advantage and market distinction. Unfortunately, most business owners underestimate the importance of these variables in business valuation.

Owners should also understand how the business is positioned in the current economic scenario. Valuation is more than just a financial number: it requires experience and specific knowledge that only a certified business valuator can offer.

An incomplete understanding of business value means that most business owners either have a vague idea or no idea what their businesses are worth. Calculating business valuation is a tricky process that gives rise to many misconceptions about the valuation process and appraisers as a whole.

Let’s go over a few prevalent myths and debunk them.

Myth 1: Business valuation uses the same multiples for similar businesses.

Fact: For a fair business valuation, one needs a deep understanding of the business and considering all the company’s financial and technical aspects–large and small. The company’s brand, expected growth rate, business model, business ideology, customer base, and other business contracts significantly determine business value. Since all these factors will differ for different companies, there can never be a “standard multiple” to assess business value.

For example, two businesses can generate the same profit of $100,000. Still, the difference is one company generates that profit by spending $50,000 while the other may need to pay $75,000 to generate the same profit.

So, there is no standard multiple for an unbiased assessment of business value. Buyers base their business value calculations on the expected return on investment (ROI); so, if a buyer wants a 20 to 25 percent return on their investment, they will translate this number into a multiple of “X” when calculating the purchase price.

Let’s consider another example: Burger King and McDonald’s are both well-known fast-food brands. Each has its customer base, but this is where the similarity ends. Both these brands have entirely different business models. McDonald’s owns most of the land where its retail outlets are built, especially in premium locations, which is then leased as long-term contracts to franchisees. On the other hand, Burger King sells regional licenses to franchisee owners and maintains no control over individual storefront operations.

No two businesses are the same, even if they operate in the same industry. Rules of thumb are not the gospel. Using “cookie-cutter” multiples can introduce risk because you can’t make an informed decision if you haven’t considered all variables.

Myth 2: Business value is derived from tangible assets.

Fact: Value is multifaceted and includes intangible assets like brand reputation, expenses, trademarks, patents, goodwill, copyrights, etc. Intangible assets give specific rights and privileges to the business, which means they have value.

While assessing the business, it’s necessary to estimate the value of all its intangible assets. Often, these assets are grouped as “goodwill,” but each is different and well-defined. Intangible assets may also be referred to as the company’s “secret sauce”–something different and special that makes the business unique and prized by its clientele. Since these assets do not have a physical form, agreeing to their value is often the most significant challenge when selling a business.

To determine the value of your intangible assets, the total value of tangible assets is removed from the overall business value. What’s left is termed “goodwill,” which is broken down further into brands, intellectual property, licenses, etc.

Myth 3: Valuation only looks at today’s numbers.

Fact: A business’s history should never be overlooked. Past, present, and future all factor into the business valuation process. The story of your company will continue past the point at which you sell. As much as possible, a buyer wants to know what the rest of the story will look like.

Business conditions change due to changes in business structure, product offerings, management, financial arrangements, market, and other general economic conditions. These internal and external factors impact business prospects, leading to changes in business value. Consequently, buyers invest in a business’s perceived viability, its stability (present and future), and its ability to generate profits in the future.

Moreover, irrespective of the business valuation approach used for valuation, it’s essential to know its history, management style, ownership structure, and financial records of past performance. Buyers perform quantitative analyses with financial ratio, growth, and margin ratios to know more about the company’s liquidity, profitability, rate of return, and more. Industry benchmarks also act as reference points to understand how the company is performing compared to its peer companies.

In short, buyers use past performance to serve as a predictor of future performance.

Myth 4: All valuations are the same.

Fact: The selection of a business valuation method depends on various reasons, including why you need one. Some methods are more complex than others, and different valuation methods calculate different valuations for the same business. Valuation quality occurs along a spectrum. A buyer’s valuation might reveal things differently than yours–and that’s okay. Realize, a seller wants to achieve a higher valuation of their business assets. To avoid overpaying, buyers prefer a more conservative approach to business appraisal.

What makes a difference is the credibility and reliability of the business valuation. Unqualified individuals or firms do not adhere to valuation standards and best practices, leading to an overemphasis on financial ratios or a market-based valuation approach.

With so much riding on the outcome of your business valuation, you should only trust a vetted, qualified business valuation service provider to give you the most accurate picture of your business’ value.

Value Scout’s expert, certified business valuation team is always willing to discuss your requirements and help you. We’re just one call away!

Myth 5: Valuation amount equals purchase price.

Fact: In business valuation, the purchase price is the total amount the buyer is willing to pay, including equity and debts. The purchase price, which is also the gross value of the business, may be higher if the buyer needs working capital and may be reduced to cover debts that are deducted to get the business’s equity value.

Business valuation is a baseline figure; it does not guarantee the purchase price. The purchase price is only one aspect of the transaction; the deal structure affects the final figures. Several elements have an impact on the deal structure, including:

  • The down payment.
  • Transaction structure–is it a stock or asset sale?
  • Financing terms (seller).
  • Specific terms of property (used for business) owned by the seller.
  • Provisions for “clawback” to protect the buyer from client/customer attrition.
  • Availability of capital for the company and its new owners.
  • Debt service coverage ratio.
  • Short-term capital needs.

Likewise, let’s not overlook taxation details: both will affect buyer and seller, whether the transaction yields a capital gain or income.

Myth 6: Having low expenses is always good.

Fact: Low expenses may mean you’re not reinvesting enough in your business, leading to a stagnation in value. When you reinvest in your business, you actually reinvest to increase revenue and profit. Moreover, when you pour capital back into the business, it contributes towards increasing your customer base, adding new business locations, or product and service range.

Reinvesting also means upgrading your business by improving operations and update your operating systems by investing in technology. Such improvements will contribute toward a better valuation. Moreover, since buyers check financial reports, going over the past budgets, tax returns, profit and loss statements, balance sheets, and cash flow projections, they will know if the cash flow is falsely inflated.

When you refrain from investing, you leave room for the buyer to negotiate the selling price, discounting the value to settle what the business lacks.

Myth 7: I don’t need a valuation to sell my business.

Fact: While technically true, you could leave a lot of money on the table without a certified business valuation. Having an accurate baseline figure gets it all out in the open when you’re ready to sell.

If you don’t have a certified business valuation report, the chances are that your valuation may be deemed implausible. To avoid this, it’s best to adhere to professional valuation guidelines and standards and engage a knowledgeable, certified professional with access to comparable and transactional market databases.

Moreover, when you engage an accredited business valuation firm, you also arm yourself with the knowledge to make informed business decisions. Business appraisal is a complex process, and only a specialist will know what information is relevant and should be included and what is irrelevant.

Valid, Accurate Data Matters

An accurate business valuation helps business owners to assess both opportunity and opportunity costs. Valuation is instrumental in the company’s future growth of the business and its eventual transition. Reasons such as disability, death, disaster, or divorce also justify the valuation to determine the value of business assets for legal purposes.

Valuation also exposes those areas of your business that reduce its value, such as under-performing assets, weak operating ratio, low financial and accounting control, etc. The complete valuation process gives an overview of the business’s strengths and weaknesses.

Our expert team at Value Scout is ready to answer your questions and give you the best valuation advice and solution. Our state-of-the-art valuation algorithm is a perfect blend of knowledge engineering and human supervision. Our valuation solution, powered by intelligent systems, is further reviewed by a qualified financial analyst.

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Alan Lambert

Alan Lambert

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