Imagine, you are looking at an impressive, theoretically correct business valuation. No expense spared. Sharp analysis. Using the standard approaches. But this does not mean that the business will sell at the price that matches its value.
Fair market value rarely equals the selling price in the real world
The reason is that the fair market value is an abstract notion. Business appraisal assumes the existence of a hypothetical business buyer and seller that are willing to enter into a deal, being fully informed of all the relevant facts about the transaction, and are not forced to make a decision by circumstances.
Business selling price is negotiable
In the real world, such buyers and sellers rarely exist. Business owners often need to sell the business in order to realize some important goals. Business buyers or investors may be looking to acquire a company that fits their specific needs and is within their budget. Access to outside capital, such as bank loans to finance business sale, may differ markedly in each case. While some business sellers may feel comfortable carrying a note to the buyer, others prefer a clean cut thus limiting the number of qualified buyers.
Most private businesses never sell
This complex mix of personal and market factors is the reason that nine out of ten small businesses put on the market never sell. It’s not that the company is not valuable. The problem is that the business sellers cannot find buyers who are willing and able to close a transaction on acceptable terms. As the saying goes in business selling it’s the terms that make or break a deal.
Price and terms matter
Look at the typical deal structuring calculation and you can see why terms may matter more than the business value. Indeed, such calculations are often used by business brokers and sellers to justify their asking price. In the process, the seller in essence declares who will be considered as a qualified business buyer. It is the party who can afford the down payment, can qualify for the bank loan, is trustworthy enough to be granted seller financing, and can survive on the cash the business can provide.
This is a far cry from the theoretical ‘willing buyer’ that the fair market value standard demands. In any business sale, you are dealing with the real seller and buyer. Each party has specific objectives that may be contradictory in nature. Bringing the parties together to some form of acceptable compromise is the key to a successful business sale.
Price your business for your target buyers
If you are working with a business broker, discussing the price and terms of a business sale is very important as it lets you focus on the target business buyer early on. Your marketing strategy is then to find the largest pool of buyers or investors who are actively searching for your type of business and are capable of meeting your terms both financially and operationally.
One value of a good business broker is to help you identify such qualified buyers and attract their attention to your business. A professionally prepared business appraisal is a must as part of your offering memo. The buyers need to know how you arrived at your asking price and what type of business sale terms you are willing to accept.
Market approach to business valuation has a lot of appeal – it offers evidence directly from the market place where the actual business buyers and sellers negotiate company selling prices. If you get hold of enough sales data, the reasoning goes, you should be able to estimate the value of a similar business. The market is seen as the ultimate judge of what a business is worth.
So far so good, but the devil is in details. First of all, what data can you get for privately owned companies? Secondly, how reliable is the data when it comes to valuing your business?
Issues with private business sales data quality
The major issue with data quality is that no private business is obligated to report its financial or operational data to the public.
This is in stark contrast to the public companies that are under the scrutiny by the government established regulatory bodies, such as the US Securities and Exchange Commission (SEC). Every company that sells its stock to the public must regularly report is financial and operational condition. All this information must be disclosed publicly and can be studied at no cost to you. See SEC’s EDGAR database online for details.
Consistent financial reporting is key for market comparisons
To make the public company data even more useful, all financial reporting must be done in compliance with major standards such as the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
This helps you make ‘apples to apples’ comparisons when you examine the market evidence of business selling prices in relation to financial performance metrics such as net income, EBITDA, cash flow, or business assets.
If you get a hold of private company financial statements or tax returns, you will quickly discover that no such consistency exists. Private companies do not sell stock to the public and thus are under no obligation to provide standards compliant financial numbers. This hampers your ability to develop reliable valuation multiples without in-depth knowledge of how each comparable company reports its financial performance.
Reasons private data services on business sales are unreliable
There are a number of private data services offering business sale data for a price. You should be very careful when using such data in any defensible business appraisal. Here are the typical problems:
- Only a small percentage of private business sales ever get disclosed.
- Financial data is collected by people who lack financial reporting expertise.
- No business sale background data is available as private companies typically wind up and dissolve following a sale.
- No background is offered to help you with financial adjustments needed to calculate valuation multiples.
Most private business sales go unreported
Most small business sales ‘fly under the radar screen’ with deals being done directly by business buyers and sellers. Since private data services rely upon business brokers to get their data, such sales never get reported. The result is that the business sales statistics are greatly skewed by the few reported deals and miss the large number of actual transactions.
Private company financials provided by players with little financial reporting training
Business brokers typically are not accountants and lack the necessary expertise in financial reporting. So one broker’s discretionary cash flow may well differ from the next. The result is that you might be comparing ‘apples with oranges’ when trying to calculate your company’s potential market value.
No background info on private business sales
Doing financial statement adjustment is a crucial step in private business valuation. However, to do this you need to have background knowledge of the company. Such information is very hard to come by and typically is not offered by private data services. The result is that you are operating in the dark when trying to assess the profitability of sold companies. Your valuation multiples may be way off base and lead to erroneous business value estimates.
Stale data, duplicate records, typos, and sweetheart deals to confuse you
Many private data services are all too eager to make a buck by selling you low quality data. Some of the more common problems with these sources of business sales:
- Obsolete business sales records, with some industry sectors having just a few sales reported over a number of years.
- Duplicate records that inflate the number of useful transactions.
- Missing fields in business sales records.
- Outliers which can seriously compromise the accuracy of your calculations.
No plug and play data – review your numbers before using!
Whatever you do, make sure you carefully review the data you get from these data services before using it in your business valuation calculations. The old adage ‘garbage in, garbage out’ is a constant reminder.
Guideline public company method to the rescue
If you are valuing a business in an industry sector with many smaller or mid-market public companies, you are in luck. You can take advantage of the much more reliable public company data to calculate the valuation multiples. Using these guideline company multiples gives you a comparable estimate of business value on a fully marketable basis. Since private firms are less marketable, you can then make the adjustment by using discounts for lack of marketability.