Part 1 – What Is My Company Really Worth?
Blue River Financial Group announces the launch of the educational series: “Straight Talk to Owners About Business Valuations” written by Managing Partner William Loftis. Our goal is to help middle market business owners and their advisors understand the importance of embracing realistic valuation expectations before entering the transaction arena. The series presents the approaches, methods, and techniques middle market buyers and their lenders employ when setting prices on the companies they acquire.
What is My Company Really Worth?
The first question every owner must answer before seriously considering merging or selling any portion of their ownership is “What is my business really worth?”. Business value ranks among the most important decision variables sellers must accurately understand if they hope to make wise and regret-free transaction decisions. Even so, reconciling aspirational ideas of value against valuation realities can be a difficult process for owners. That’s why this article begins with a frank caution to owners: It is in your interest to understand the real value of your business and not embrace indefensible ideas. Wrong valuation expectations nearly always produce undesirable transaction results that can leave you with long lasting regrets.
Valuation Observations from Owners Who Sold Businesses
When interviewing owners who previously sold their middle market businesses, several common traits were observed:
- For most owners, the business represented the lion’s share of their net worth – often exceeding the value of all other assets combined.
- Most reported they knew the market values of their real estate holdings, stock portfolios, 401ks, car collections, etc.; but they did not accurately understand business value until it was time to sell.
- The business was their primary source of personal income. Most trusted their ability to generate ongoing income and wealth through their privately held businesses more than traditional investment vehicles like stocks or real estate.
- Business value was the most important negotiating point in transaction discussions. Little serious attention was devoted to other issues until a price was substantially agreed upon.
- Some had their CPA prepare a business appraisal (a.k.a., valuation). Even so, many were required to reduce their price expectations in light of buyers’ persuasive arguments.
- Most sold for a lower price than they originally planned.
Most former owners report that it if they had it to do over again, they would have tried to understand business valuations much earlier in the ownership cycle. One owner said, “I always had an idea of what my business was worth, but I was wrong. Unfortunately, I didn’t discover how wrong until I tried to sell it. By then, I was too old to meaningfully influence its value.”
Consequences of Valuation Mistakes in Transactions
There are two main problems for owners who make mistakes when selling:
- The stakeholders only have one chance to get it right. Mistakes and missed opportunities tend to be permanent and unrecoverable. Just as chess players are stuck with the move when the fingers are taken off the chess piece, owners are stuck with the business sale outcome when the closing documents are signed.
- The stakes are extremely high. Since middle-market companies usually represent the largest component of an owner’s net worth, transaction missteps create disproportionate adverse financial consequences to owners and their families compared to other business decisions.
When it comes to business values, owners err when they underestimate or overestimate the value of their companies. If an owner believes his/her company is worth less than it really is, a transaction at a lower value permanently deprives the owner and subsequent generations of accrued wealth.
In most cases, however, underestimating value is not the owner’s problem; overestimating value is. Multiple M&A industry surveys have repeatedly indicated through the years that the primary cause for failed M&A transactions lies in unrealistically high valuation expectations of sellers.
It is a paradox. Owners routinely make business decisions based trustworthy assumptions that lead to entrepreneurial success; yet, when examining the value of their own companies, they frequently turn a blind eye to valuation fundamentals. An upcoming article will explore some of the reasons and creative ways owners use to justify higher values. For now, it is important to emphasize that embracing aspirational rather than realistic notions of value generally creates negative consequences for owners such as:
- Corrective Opportunities Lost – Owners who wait until late in the ownership cycle to discover real business value are often too late to take make significant valuation improvements. Value creation is a long process. Therefore, the time to meaningfully influence value is years before it’s time to sell. It is always a sad day when owners realize the proceeds from a sale will not support a retirement lifestyle at the same level enjoyed as owners.
- False Starts – Selling a privately owned business is a disruptive process. It involves sharing extensive amounts of highly confidential information with potential acquirers. When owners take their businesses to market with unrealistic expectations, there is little likelihood a transaction will occur. So, why would owners expose themselves and their businesses to the risks associated with sharing confidential information if there is little hope of finding a buyer? Perhaps advisors provide bad advice. Perhaps owners believe it only takes one buyer. But, let’s be clear, investors in privately held middle market companies have money to invest, because they don’t make bad valuation decisions.
- Opposite Effect – False starts have an adverse impact on business value. Here’s why: The universe of acquirers for privately held middle market companies is finite. It mostly consists of professional acquirers like private equity funds, family offices, and larger corporations. This set of potential purchasers represents the demand side of the supply-demand equation. Professional buyers are able to discern the seller’s valuation expectations. If unachievable, the best buyers quickly pass on the opportunity. As buyers withdraw from the competitive process due to a seller’s unrealistic valuation expectations, market demand for the business wanes. As demand diminishes, sellers must convince buyers that something has changed to reignite interest; which usually involves communicating some sort of downward price adjustment. Consequently, overly aggressive valuation expectations tend to backfire on sellers and ultimately drive the value of the business down. Owners should never take their businesses to market unless they have a solid understanding of the realistic potential valuation range.
- Post-Closing Risks – It is very rare for acquirers to substantially overpay for a middle market business, but it can happen. When buyers overpay, they can find themselves dealing with a host of unwanted consequences such as:
- The business falls out of compliance with loan covenants.
- Unsecured or subordinated lenders collaborate with senior lenders to protect their positions against the borrower.
- Equity investors stand to lose their entire investment.
A seller might say, “The buyer’s loss is my gain. Why should I care about the buyer’s post-closing troubles?” The answer is that we live in a litigious society. Buyers who significantly overpay will often find reasons to blame the seller for their misfortune. Allegations against sellers are predictable:
- The seller withheld material information.
- The seller misrepresented facts.
- The seller defrauded the buyer.
- The buyer prays for relief including rescinding the transaction along with appropriate damages caused by the fraud.
Once the buyer’s attorney formalizes accusations against the seller, the sellers can expect to be in for an expensive process regardless of their innocence. Attorney involvement means the righteousness of one’s cause is no longer the issue, but how much must be paid to avoid the expenses of long-term discovery and uncertain trial outcomes.
The list of consequences tied to unrealistic valuation expectations could go on; but the key point is that nothing good comes to owners who make decisions based on bad information.
The primary tenet of financial management is to make decisions to enhance the wealth of a company’s stakeholders. To measure if strategies are delivering hoped for valuation improvements, there has to be a baseline valuation with regular updates. For example, if a business is worth $5 million today and the owners want to exit in 5 years for a sale price of $15 million, strategies can be devised and executed to realize that outcome. Progress toward the final valuation should constantly be examined by using the same realistic assumptions buyers and lenders rely upon. When owners keep realistic valuations at the forefront of measuring business success, awareness of value drivers increases. Owners also become fluent in financial lingo, which is necessary when negotiating for higher values with sophisticated acquirers. The best transaction decisions are always based on realistic valuation data. It is never in an owner’s interest to embrace faulty notions of business value.
In an upcoming article, we will share how middle market acquirers determine purchase prices on privately held companies. Stay tuned to find out more!
 For over two decades, the author interviewed hundreds of business owners inquiring about various transaction aspects.
William “Bill” Loftis is Managing Partner and co-founder of Blue River. Mr. Loftis developed a passion for M&A as a transaction principal, and has assisted buy and sell-side clients through the M&A process in multiple industries. He earned a B.A. in Business Administration from Alma College and a Master of Science in Finance from Colorado State University. Bill’s full bio is available here.
About Blue River
Blue River has been representing middle market business owners and professional acquirers through the merger and acquisition process for nearly two decades. We understand transaction values from the theoretical and practical levels like few others. Since transactions depend on funding, we blend traditional appraisal methods with advanced modeling used by banks and professional investors to support our opinions. Our findings are supported by internal and external industry transaction databases, original research, and experience.
If you plan to sell all or a portion of your company in the near term or over the next 5 to 10 years, transaction value will likely be among the most important decision variables. The sooner you understand how key internal and external drivers affect value, the more time you will have to strategically influence outcomes. Contact us to schedule an appointment with one of our Certified Valuation Analysts.