If you run across a business whose value seems to be too good to be true, you may be right. Since business valuation relies upon the estimates of business earnings, overstated earnings could easily be misleading.
While reasons for inflated business earnings are legion, here are the top five ones to watch out for when valuing a private company:
1. Deferred maintenance
Business owners may opt to use key assets to generate as much cash flow as they can. If the owners are planning on retiring or selling the business, they may deliberately neglect the need to repair or replace aging machinery or equipment. This distorts the cash flow picture while sweeping the required capital investment under the rug.
A new owner may well be stuck with high outlays trying to bring the business assets up to snuff.
Some business owners are masters at running their companies on ‘vapor’. They use generous credit terms from established vendors and aggressive receivables collection to reduce working capital requirements.
They may be able to raise long term capital from family or friends on terms unavailable from commercial lenders. For a new business owner, such terms may simply not exist.
If you are valuing a private company, carefully review the actual short and long term capital needs the business requires to operate successfully.
3. Understated payroll
Employees are the lifeblood of any business. Key employees must be well compensated to be attracted and retained. In a small business, these critical jobs are often performed by the business owners themselves who work for ‘sweat equity’.
If the business sells, the new owners will have to find a way to replace these critical skills. They may be shocked to find that the availability of such skills in the market is scarce or that the hiring cost is prohibitive.
4. Underweight marketing and sales expenses
An established private company may be relying too much on the word of mouth to keep running. Should the business need to enter new markets or defend against a new strong competitor, the funds to plan and execute effective sales and marketing campaigns may become a major drain on cash flow.
Carefully establish what the business needs to budget in order to promote its market position and reach existing and new customers. Then incorporate these requirements into the estimate of business earnings that ultimately affect what the business is worth.
5. Hidden operating costs
Successful businesses usually have a ‘trick up their sleeve’. This may be an innovative process that makes it highly efficient, or a line of products and services that attracts customers. The costs of internally developing such trade secrets can be considerable. However, they are typically not stated on the company’s financial statements.
Equally important, the skills and expenses associated with keeping the competitive edge may be unclear until you find out that the departing owners or their key employees take with them the essential part of what makes the company tick.
Missing these hidden cost drivers could come back to bite you when an obsolete product line needs upgrading and you find to your amazement that no one at the company knows what to do.