Not long ago I met with an owner who was thinking about selling her business. She proudly presented a valuation report prepared by her CPA who did not have valuation training. The report suggested the business was worth $20 million. A quick glance revealed incorrect methods, wrongly applied data, bad assumptions, and, most importantly, a vastly inflated value. If the CPA had taken commonsense steps to corroborate his own findings, he would have discovered at least two reasons why $20 million was unachievable. First, the value was tied to strong earnings growth projections that had no connection to company’s flat historical performance. There were no new initiatives, customers, product lines, or other elements that could explain the high growth projections. The CPA relied on the owner’s hope that the upcoming election was bound to increase her business. It was a classic “hockey stick” forecast. Few buyers will pay cash for a business where much of the value is tied to unsupportable projections. Had the CPA estimated a buyer’s expected return on a $20 million investment in light of historically reasonable growth projections, he would have found returns below a bank CD rate, which would have attracted exactly zero professional investors.
The second sobriety check the CPA might have applied was to measure borrowing capacity based on the company’s free cash flows and balance sheet assets. The verification process revealed that the company’s free cash flow and assets could not support a loan greater than $5 million. A buyer would have had to contribute $15 million in equity to buy the business at $20 million. Even with leverage, the return on investment was below 5%. It is said: “A fool is born every day”, but fools are not the ones with millions to spend.
When I shared that her business was probably worth closer to $10 million than $20 million, the owner acted as if I had just stolen $10 million from her. I endured her scorn as she indignantly huffed and puffed that my observations were wrong. She demanded that I recant my thoughts as if I controlled reality. In a royal outrage, she stormed out of my office muttering something about my character and a guillotine.