Business valuation: the danger of overvaluation

Broker Andrew Rogerson says he cannot recall a single undervaluation

Overvaluation is a perennial problem of selling a business.

Andrew Rogerson, a business broker who is experienced in valuation and has operated and sold his own businesses, encapsulates the problem perfectly: “People think ‘I’ve been working on this for 20 years so it must be worth a lot of money’ – but it’s really about the cash flow of the business. That comes as a shock to many business owners; they put their heart and soul into the business and think it’s worth a lot of money.”

It’s difficult to be impartial about something you’ve created, which you’ve spent years of hard work building and which to an extent defines you.

“It’s very common for sellers to have this expectation, especially if they’ve been working in the business over a long period of time,” continues Rogerson, owner and managing director of Sacramento Murphy Business and Financial Corporation Office.

Don Glossop, managing director of Andon Frères, also says that brokers can reluctantly collude in valuing a business too highly so as to avoid alienating potential customers. "It's fair to say that most vendors tend to overvalue their businesses and unfortunately, some brokers overvalue businesses because that's what the vendor wants to hear and to improve their prospects of securing the business.”

The sad truth is that of the many thousands of businesses currently on the market, the majority are set at an extremely optimistic asking price – to put it mildly

Derek Burgoyne, Cornerstone Business Agents

Vendors, he suggests, “should remember that a broker has nothing to gain by putting forward a low valuation; it's likely to be an honest appraisal based on information provided and his experience in the marketplace.”

Regardless of what established formulae – and it’s never an exact science anyway – indicate a business is worth, ultimately, a business is only worth that amount if there’s a buyer in the market willing to pay it.

Says Glossop: “Vendors should remember that the broker doesn't determine valuation. This is determined by what a buyer is prepared to pay and what a vendor is prepared to accept, and without agreement by both parties, there will be no deal.

Misleading

Sometimes, a vendor can get lucky and recoup above the value that accepted methods of valuation arrive at, as Norman Younger of Kensington Business Brokers explains: “It could be that a buyer has a particular reason for wanting that particular type of business or location, so to them it's worth more than to most people. That would be an overpayment in terms of market value, but not from their point of view.”

However, this could mislead other vendors into thinking that price is the benchmark for businesses with comparable profits, reputation and potential, when in actual fact it is an anomaly, as Younger warns. "Some people might look at how much a buyer paid for 'X' business to determine the price of another business, not realising the misleading reasoning behind the valuation."

Andrew Rogerson says he can provide “example after example” of vendors with an inflated sense of their business’s worth. He cites an example where three months into the sales process a vendor who believed his business was worth around the $1m mark asked him to conduct a valuation. “By the time I got his tax returns and did the analysis I had to deliver the unfortunate news that it was only worth about $110,000, so he was a bit shocked about that.

“I also did an appraisal for a technology company and the guy called me about eight months ago. He thought the business was worth about $8m, but I did the appraisal and it was worth just over $1m.

Derek Burgoyne of Cornerstone Business Agents echoes his sentiments about the naivety of vendors: "The sad truth is that of the many thousands of businesses currently on the market, the majority are set at an extremely optimistic asking price – to put it mildly.

“This is the price the business owner would like to achieve and no one has put him or her right. Even if good advice is given, it is often ignored.”

Burgoyne suggests however, that there are other reasons behind overoptimistic overvaluations aside from the bias of the owner:

• This is the price the business owner needs to achieve – to cover loans, pay the agents, banks and other creditors. David Rhodes recalls such an instance: "On owner told me that if he couldn't get a certain price for his business then there was no point in selling it, as he couldn't pay off his debts otherwise, in which case he’d rather go bankrupt. Others simply want to get their original investment back."
• An agent with little experience has suggested the price (the less experience and confidence an agent has in his orher ability to value a business the more likely he is to overvalue to please the client)
• An agent suggests the price as a way of gaining the instruction as a sole selling agent. This enables them to get a large up-front fee or to make it more likely that he or she is instructed ahead of a competitor (with the intention of going back to the client after a period of time to suggest lowering the price if no interest has been generated)
• There is a lack of financial information supplied to the agent, who then has to value on verbal indications of turnover and profitability. As most owners usually overestimate their turnover and profitability, the business is overvalued

"Sometimes people don't like the truth,” says David Rhodes of Horizon Business Agents, who believes that not all vendors are naive or deluded. “Overvaluations often happen because the vendor gets greedy. A number of times vendors have told me that they knew their business wasn't worth the figure they'd asked, but they thought they'd give it a try anyway.”

Overoptimism

Norman Younger uses the analogy of selling a house to explain how a buyer’s judgment can be clouded by the vendor’s misplaced optimism: “When the vendor has a particularly good business and believes it's worth above and beyond its true value, they can hold that view so strongly that the buyers believe the hype. It's like houses, when people put crazy prices on them and people pay it because they're scared of getting left behind.”

He also flags a lack of research as a problem: “Then of course you get a buyer who doesn't do his homework properly and doesn't want to follow the advice of his agent.”

So, do people ever undervalue their business? Andrew Rogerson is unhesitant and unequivocal: “I’ve never come across a business owner who has undervalued their business; it’s always overvalued, often quite considerably.”

Ensuring an accurate valuation

So how do you overcome your natural bias? How do you arrive at a valuation which reflects the market and the profitability, both present and potential? How do you decide on a price which you have a realistic chance of realising?

Derek Burgoyne suggests: "Invite two or three agents to value the business and ask for an explanation each time of how the value was calculated. The explanation should include examples of similar businesses recently sold – or on the market at least – and what adjustments and multipliers have been applied to the net profit to value the goodwill of the business.

"Advice should also be given on how the value could be increased. What improvements would have to be made to the property, should the lease be extended, what financial information should be provided, etc."

Having sought out the views of some top brokers in the industry, it’s clear that there are certain things vendors must do to ensure they do certain things to minimise the risk of overvaluation:

• Appoint the right broker – ideally someone with experience valuing businesses in your sector
• Listen to the broker – he’s objective in a way you simply can’t be, and he’s experienced in valuing and selling businesses
• Provide the broker with all financial information requested; be as thorough as possible
• Remember that the true worth of a business is about the income it will generate for the owner, and the potential for growing that income. It has nothing to do with the number of hours you have invested in building the business; sentiment doesn’t come into it

Find out some tips on buying, selling and starting businesses, courtesy of Robert Ward, who has experience in all three