This is a very good question to ask when you value a business: what value is actually calculated? A business owner or investor is most interested in what their part of the company ownership is worth. On the other hand, if the company is offered for sale, the value of the entire enterprise needs to be determined.
Why this difference? Simply put, because the intent of business valuation is quite different. It is one thing to figure out what your piece of the company is worth for the purposes of estimating personal wealth. It is quite different to establish the company value for acquisition. Business buyers need to come up with their own capital, both debt and equity. It matters little to them how the current owners fund the operations.
This holds true regardless of whether the company sells in an asset sale or as part of a stock transaction. The enterprise value is the sum of what the equity owners and creditors hold. If the company sells in an asset sale, the seller delivers company assets free and clear, paying off the business debts before the close.
In a stock transaction, the buyer assumes the firm’s liabilities. The actual value of the business, on an enterprise basis, is still the sum of owners’ equity and liabilities as assumed.
That’s why the convention for business valuation is to figure out the business enterprise value. It is then pretty straightforward to calculate the owner’s equity as the difference between the enterprise value and the liabilities.
Buying debt-free companies using a lot of ‘other people’s money’ can be dangerous if the leverage exceeds the company’s capacity to repay. It may seem attractive at first, but many a business went broke following a heavily leveraged acquisition that drained the company’s cash flow.
To make matters even more interesting, some business owners might want to calculate just the value of their ownership interest. If you own less than a controlling share of the business equity, then it might be worth less than simple pro-rata reckoning would suggest.
That’s because the actual market value of a partial business ownership is established by investors. Savvy investors don’t have much appetite for owning investments with lots of strings attached. Controlling business owners may impose severe restrictions on how such share of business can be sold and what dividends look like. Changing how the company does business is really hard unless you control it.
This lack of control comes with a major discount to your business ownership value. Business appraisers use a formal term to describe this situation – discount for lack of control. As the name implies, you own less than you think if someone else controls the company.
Business people and professional advisers love business sale transaction data. After all, what is a better indication of private business value than the data on sales of similar companies? Sounds like a no-brainer, right?
It does, until you realize that the quality of business sale data leaves much to be desired. Consider the facts: unlike public companies, private businesses are not required to report acquisition deals to the public. Financial reporting of small business sales is not done by experts, such as accountants, to comply with the GAAP (generally accepted accounting principles).
Apples and oranges: private companies do not report financials consistently
A company’s EBITDA or discretionary cash flow may be very different than the figures reported by its industry peers. That could throw a real monkey wrench into your valuation multiples calculation.
Most private business sales data are not for sale
In addition, most private business sales fly under the radar screen and never get picked up by the private business sale data services. These deals are often done between competitors or using the in-house M&A teams, so details remain private. Many business brokers are very competitive and do not report their deals to anyone, considering this data in their possession as a key competitive advantage. In short, most private business sales data is not for sale.
Business sales data reporting is sketchy
Even the deals that do wind up in the private databases are often lacking in quality. Since no independent auditing of business sale data is required by law, business sale data vendors offer you pretty much what then can get away with. Some of the most common pitfalls are these:
- Missing data fields in business sale records
- Typos in numerical data such as misplaced or missing decimal symbols
- Wrong SIC and NAICS industry classification assignments
- Duplicate transactions that skew your calculations
- Data that is out of date
- Business sales outliers of questionable quality
Private databases may fail to supply all the relevant fields for each record. Since the reporting is voluntary, expect some fields to be missing and make adjustments to your calculations accordingly.
Data entry is another major source of errors in business sales databases. Check to ensure no missing or misplaced decimal point symbols. If you don’t, your calculations can be very wrong.
Bogus SIC and NAICS industry codes = misleading business valuation result
The industry code assignments deserve special attention. When extracting data sets, do not assume that the transactions are relevant to your target business. SIC and, especially, NAICS code assignments are often in error in private databases. This is particularly troublesome for Internet businesses, emerging technology companies or high tech manufacturing and software firms. Since the SIC and NAICS codes are often used to select the business sale records from the databases, always check your data set to make sure you don’t run an ‘apples to oranges’ comparison.
All business appraisals must be relevant and timely. Watch out for dated transaction records that bear no resemblance to the current market conditions.
Duplicate records creep into private business sale databases, enabling the data vendors to claim high transaction counts and charge you accordingly. However, your data set must be free of such misleading data to serve as a relevant comparison base.
Business sale deal numbers that look too good to be true probably are. Remember, there is no independent auditing of the transaction figures, so the data lands in the database as is. When in doubt, carefully consider what looks like an outlier. You may need to exclude such records from your comparisons.
Review your data before you plug it in: garbage in, garbage out
The effect of these errors lends credence to the old adage of ‘garbage in, garbage out’. If you decide to use private databases in your business market value analysis, be sure to review the data before running your business value calculations. Otherwise, you run the risk of coming up with bogus conclusions and embarrassing questions from the readers of your business appraisal report.