When a business owner is selling their business, the valuation is the most important factor in the equation. A company’s valuation is based on the businesses earning power and risk assessment, the assets that they own, and the value given in comparable transactions. Since many of the factors included in the business valuation analysis, such as the earning power and the risk assessment, require some estimation to determine, there is room for overstating the business valuation. Of course, it is in the best interest of the owner for the business valuation analysis to show a higher dollar amount, since it leads to the ability to generate more cash in exchange for less equity from investors, or a bigger pay day when the business is sold. For this reason, sometimes owners incorporate subtle inaccuracies into business appraisal valuation to overstate its price tag (and sometimes, it’s unintentional, the numbers are just hard to nail down).
As such, when a business valuation seems too good to be true, it often really is. Five ways that a business valuation analysis can be overstated include:
- Ignoring Maintenance on Key Assets
Let’s say an owner is doing a business valuation analysis for their doughnut shop. They own their doughnut equipment outright, and it is a key asset that gives their business greater value. However, their equipment requires $20,000 in annual maintenance, and since they knew they were on the way out, they simply ignored this expense this year. By doing this, the business valuation report shows the value of their doughnut machine, but it also factors in additional $20,000 in cash flow that they would not have if they had maintained their critical asset. When the business sells, the new owner will have to shell out that cash to bring the equipment up to speed.
- Under-reporting Capital Requirements
Sometimes, established business owners are capable of running their business without sufficient capital by robbing and Paul to pay Peter. They use their grassroots credit terms (with old friends and connections) to acquire materials and then wait until they have make the cash back pay back the costs that were required to generate the profits. When to businesses is sold to a new owner who doesn’t have such connections, this will not be an option, and the owner will need to have more capital than the business valuation calculates in order to continue operations.
- Minimized Payroll Expenses
A small business owner often serves as their own administrative staff, HR department, marketing department, IT guy, and onsite handyman. While it might keep operations afloat for the owner, a new person couldn’t just step in and immediately take over all of these hats. Since these roles are critical in order for the business to function, and the original business owner has not been charging the business payroll expenses for them himself, it makes the cash flow appear better than it really is. When the business is sold, and the new owner finds themselves having to increase the number of employees to operate the business, it reduces the cash flow and net worth of the business.
- Unstable Market Position
Sometimes, a small business owner is able to rely on word-of-mouth to keep profits coming in. However, as the industry changes and competitors enter the market, additional costs for marketing and business development will be incurred to maintain sales. When a business owner knows that he’s on his way out, he isn’t as concerned about the future of the company, and isn’t putting money towards these marketing expenses. This overstates the cash flow since the new owner will have to spend money to ensure the stability of the company in the long-term.
- Hidden Operating Costs
Often, the “secret sauce” that makes a business successful comes with intangible costs. The owner’s knowledge and great reputation, or the efficiency of highly skilled employees, are the reason the company has such a great success rate. If these hidden profit drivers are not figured into the valuation, the new owner may not understand why the business’s forecasted earnings aren’t being met when that secret ingredient is removed from the equation.
Do you know of any other factors that lead to a business valuation analysis being overstated? Please share them in the comment section below!