Smith Holland M&A Resources
Unrealistic valuation expectations are the top factor impacting deal lifecycle timeframe.
Most business owners seem to think they can put an accurate value on their company, but this can make all the difference when trying to sell your business. Unfortunately, what many sellers do not understand is that they are emotionally invested in their business and more often than not, have unrealistic valuations. Since most qualified buyers have already wasted time with sellers who have unrealistic expectations, companies with high multiples will often times get passed over and experienced buyers won’t even take the time to explore the opportunity further. As a result, there are a substantial number of businesses that do not sell because they are overpriced or the seller is unwilling to negotiate fair market value with a potential buyer.
Real Estate vs Business Valuation
Market comparisons for real estate are well-established and publicly available, making it easy to value. For example, a home owner is looking to sell their house. After reviewing similar comps in the local market with same number of bedrooms and bathrooms, the average sale price is approximately $500K. If that home owner puts an asking price of $1MM for their home, essentially wanting double the price over houses in the same area, we all know what will happen. The home owner will become frustrated and either pull the property from the market months down the road or have to sell for a reduced price after all the qualified buyers purchase other reasonably priced houses. This is obviously a huge waste of time and energy for the home owner.
On the other hand, valuations for businesses have moving parts and are completely different than real estate, making them more difficult to value. There are a number of variables to consider but the simplest valuation includes a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA). Depending on the industry, these valuations typically range anywhere from 1x to 5x multiples of EBITDA. For this reason, an unrealistic business valuation is the same as an overpriced piece of real estate. If comparable businesses in the industry are selling at 2.5x EBITDA multiples and a seller goes to market with a 10x EBITDA multiple, expect similar results. The seller is going to waste not only time and energy but money as well.
Common Reasons for Unrealistic Valuations
Besides being emotionally invested in their company, sellers often display symptoms common to most business owners once the decision has been made to sell.
The most common reason for unrealistic valuations is when a seller compares their business to public or viral online companies such as Facebook, Instagram, Pinterest, Uber, etc. These companies have raised millions in capital and registered millions of users, so comparing these biggest companies in the world to ordinary businesses for sale is completely unreasonable. The traditional company seller is not going to get a 50x EBITDA multiple nor should they expect this from a buyer.
Another common reason for unrealistic sellers is when valuations are based solely on sales revenues. Sellers will be disappointed if they only look at sales revenues and decide the company made $3MM in sales last year, so the valuation should be at least $3MM. Business owners need to understand that millions of dollars in sales is applaudable but if that same company made $3MM in sales but only $500K in EBITDA, fair market valuation will most likely be less than expected.
This is also the case when sellers look only at net income. A misperception in the industry is created when a business owner thinks because their net income increased, the valuation multiple should as well. While it is much more attractive to a buyer when a company has higher EBITDA figures, this doesn’t mean that the valuation will improve from an average 3x multiple to 4x.
The most obvious reason for an unrealistic business valuation involves sellers’ requirements or wants. Ignoring fair market valuation for a company and instead going to market because a seller needs “this many” millions of dollars is more common than you would guess. Retirement is a normal reason for a business owner to sell a company and buyers understand, but don’t think those buyers are willing to pay a premium for retirement. No matter what the reason for selling, buyers are only willing to purchase a business at fair market value and usually, they want a better deal than that.
Institutions and experienced buyers will only pay market value based on an industry EBITDA multiple that is reasonable. Unfortunately, the most important figures that buyers examine are bottom-line revenues and how much cash the company is actually bringing in year over year (YOY). When a business owner tries to add value from inventory, equipment, assets and non-cash flows that don’t produce revenues for the company, there may be a disconnect in valuation between buyer and seller. If a business owner paid $400K for equipment or $300K for inventory last year, it’s not likely a buyer will pay full price for that equipment and inventory at closing.
While most sellers seem to think they can put an accurate value on their company, more often than not, these business owners are emotionally invested and have unrealistic business valuation expectations. Experienced buyers have likely purchased companies in the past and unfortunately for sellers, won’t even take the time to examine overpriced or high multiple businesses for sale on the market. These buyers understand what dealing with an unrealistic seller means and as a result, there are a high percentage of businesses that do not sell because the company owner is unwilling to negotiate fair market value.
Sellers often display symptoms common to most business owners once the decision has been made to sell. It is very important for companies to take the advice of a professional mergers and acquisitions firm that can guide sellers through the valuation process and price the company appropriately for a sale. The majority of traditional businesses for sale will not come close to a Facebook or Instagram valuation and therefore, will not get 50x EBITDA multiple for their company. Since a trusted M&A advisor has closed hundreds of deals and knows the market inside and out, sellers can save not only time and effort from the frustration of an overpriced valuation but more importantly, money.
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