I admire business appraisers. They diligently and patiently wade through reams of information, doing math, statistics and database work while keeping their heads down for long periods of time. So I don’t mean this blog post as being critical of their work. Most do great work – but even great work isn’t perfect, especially when the data being used isn’t perfect.
First, know that there are more than one valuation number for a business. Here are a few:
– The appraised fair market value of a business
– The estimated range of market value from an intermediary
– The actual selling price after marketing the business
– There are also book value, net asset value, etc. but they are usually irrelevant
So why would an appraised value, after all that work by an appraiser in producing a 50 page valuation report, be far off from the actual selling price?
- The appraiser may be biased. Who did the valuation, and did they have other motives? If you went to a seminar and had a national M&A or brokerage firm do your appraisal, it could be they wanted to give you a high value so you’ll sign up with them. I’ve seen some wildly high valuations provided in these cases. But they did come in a beautiful binder with lots of color graphs. If you want an unbiased formal valuation, it has to come from an unbiased appraiser, and you have to pay for that.
- The market has changed. Most small and mid-sized business are valued with the “market approach”, similar to how real estate comps work. You can look through your formal valuation and it should state clearly what approach was used. Typically a search is done using done-deal databases for the past few years and this is averaged (sometimes in a complicated way, but still basically averaged). In other words, past market conditions are used to value the business. An appraiser may guess at the current market conditions, but it is only a guess. Generally, the market for quality businesses is pretty even, but obviously there are trends such as in construction, lending, etc.
- Bad data. This is the dirty secret of the valuation world. The data often stinks. For example, as an appraiser you might find ten comparables when searching for steel building manufacturers. One seems way too high. You call the intermediary that did the deal (if you can find them) and find out that real estate was included in the sales price. You adjust. Another may seem way to low. You call and find out debt was assumed by the buyer, but wasn’t accounted for in the sales price. You adjust. But you can’t call each one, so errors slide through. You hope that over all, you have enough numbers and the data is good enough to nail down a reasonable range of values. I’ve seen, however, that sometimes enough bad data gets through to slide the final valuation number away from the true market value.
- The company has changed. Right now, unfortunately for us all, we have a market where the performance of companies is uncertain and volatile. The market approach assumes the financial history of a company predicts its future. But if potential buyers see uncertain or falling numbers, the offers will be lower.
- The Income Approach relies on a guess. The other approach most commonly used for larger companies is the income approach where future cash flows are used to calculate present value. The problem? It is really just an estimate of future performance, and in this market that often boils down to a guess. A potential buyer may not have the same faith in the estimate that a seller or appraiser does.
After re-reading the above, I can see how one might think that formal valuations may never be correct. However, they often are very good at being in the ball bark although I never rely on them for being spot on. Occasionally they are way off.
Do you need a formal valuation to sell?
My opinion is no. You do need a formal valuation if there are no market forces at play to determine the best price. For example, if you need to know the value of a business for a divorce, court case, partnership buyout, etc.
However, for a sale what you need to know is a range of values you can expect to get (so you can determine whether you even want to sell!). A good business intermediary will provide that to you. For example, at the Woodbridge Group we do a financial analysis and use done-deal databases and our accumulated experience to provide an estimate of value at no charge. If a potential client agrees to that value range, only then do we represent the client in sales engagement.
We don’t set a price for the companies we represent. We set up a competitive bidding environment and with our marketing programs we allow free market forces to set the price. The best price. Because, after all, you can have 10 valuations done. None will match the others, and the only value that really matters is the final purchase price – the value that that one unique buyer will see in your business.
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