Business owners like to think they know what their businesses are worth. In most cases, unaided by professional valuation guidance, the typical owner will overvalue his or her business. Or, perhaps worse, he will undervalue the business in his mind. We all like to think we are the exception, rather than the rule, or at the top of the value scale. It just isn’t so for most businesses. As a statistics professor said many years ago, “That’s statistically impossible for everyone to be above average. Below average, average, or above average, it doesn’t matter how owners often think about the values of their businesses. Let’s see why.
Let’s first look at why owners think what they think. The answer relates back to the basic valuation equation we have been talking about.
Virtually every business owner is familiar with the concept from the basic valuation equation of value being a multiple of earnings. So they sometimes think there is really nothing much to this business valuation thing. All you have to do is to determine what earnings are and what the appropriate multiple is. That’s why so many business owners think they know what the values of their businesses are. They think they know, for example:
- What the earnings of their businesses are. The reality is, business appraisers and people who buy companies usually look at earnings differently than do business owners. We’ll talk about how appraisers look at earnings shortly.
- What multiple that should be applied to the earnings. Every business owner has heard of a friend or competitor that sold for, say 6x some kind of earnings. They may not know which earnings, but they remember the 6x. Or they have heard that the multiple range for companies like theirs is 4x to 6x earnings. They usually remember the high end of the multiple range, but it may not be clear to what indication of earnings they are applied. And there is a 50% difference in value between a 6x multiple and a 4x multiple! And, of course, your business is worth 6x earnings! Maybe.
Armed with what they think are the earnings of their businesses and with some rumor or rule of thumb for a multiple, many owners really do think they know what their companies are worth.
I’ve said many times that if you are a business owner, it really doesn’t matter what you think your business is worth. Only two things matter:
- If you are transacting while you own the business. If you are transacting for any of a variety of reasons, like gift tax planning, buy-sell agreement pricing, buying back shares from shareholders, or others, what typically matters is what a qualified business appraiser concludes. Most people won’t make significant investment decisions, like buying or selling closely held shares, without an appraisal from a qualified appraiser.
- If you are selling your business. If you are selling your business, the only thing that matters is what buyers of capacity think it is worth and will pay for it. And it is better if multiple buyers are competing for it, so don’t rely on what you think in this circumstance either. Be sure your business is READY for sale all of the time. Then, go into any eventual selling process with appropriate valuation knowledge and deal-making advice.
There are many good reasons for business owners to have solid knowledge about the values of their businesses. I talk about several reasons in my book, Unlocking Private Company Wealth, including:
- Monitoring performance. If you think about it, no business owner can know the rate of return on his investment in a business without knowing its value at the beginning of a year (or the end of the last year) and its value at the end of that same year. You also need to know what benefits or distributions were received over normal compensation for working. We will talk about this concept later.
- Buy-sell agreement pricing. Every successful business with two or more owners should have a buy-sell agreement. As I conclude in my book, Buy-Sell Agreements for Closely Held and Family Business Owners, the best pricing mechanism for most businesses is some form a single appraiser valuation process.
- Life insurance. It is handy to know what a business is worth when buying life insurance on the part of owners.
- Estate planning. Owners desiring to make gifts of closely held stock to their children must do so based on independent appraisal. And the discounted valuations used for gifting purposes are different than the value of a business we are talking about here.
- Retirement planning. I wrote two blog posts, here and here, about two business owners, Martin and Steve, who had similar businesses and different lifestyles. Martin should have known the value of his business long ago. For most business owners, the value represented by their businesses represents a large portion of their net worth. If you are planning on realizing that value as part of your Business End Game, then you better have a realistic understanding of value, because that value will fund a substantial part of your retirement.
For all of the above reasons and many more, business owners need solid, dependable knowledge about the values of their businesses. So you see, it really doesn’t matter what business owners think their businesses are worth – unless their opinions are informed by solid valuation guidance.
Until next time,