Why do entrepreneurs overestimate what their business is worth?
Many entrepreneurs have an unrealistic idea of how much their business is worth. That is not surprising: research shows that people invariably attach a higher value to things they own than to things that aren't theirs — the “endowment effect,” explained in the Harvard Business Review article “Why Buyers and Sellers Inherently Disagree on What Things Are Worth.” The first step in preparing for estate planning, recapitalization, or a full or partial sale of your business is to recognize your own personal bias as the owner and understand that an investor, buyer or independent third party is likely to value your business differently.
Why does business valuation matter so much for entrepreneurs?
Setting a value for a business isn't easy, but the value (or sale price) you produce — along with the value drivers of your business — becomes an important focal point of your company's ongoing growth and eventual exit plan. You may have a different value in mind than your family successors, potential buyers, investors or tax assessors. That difference can cause conflict and may affect your business's growth and your personal retirement plans if you do not understand it. This is especially true if you intend to give the business to a family member: you will need an objective valuation to ease family disputes, plan your estate and minimize your tax treatment.
Business valuation estimates the economic value of an owner's interest in a business. Various parties use it to determine the price they are willing to pay or receive to invest in or take part in a full or partial sale, and valuation methodologies are also used to distribute purchase price among business assets or estimate a partner's ownership interest when selling, buying, acquiring, merging or structuring a joint venture.
What valuation methodologies are used to set a sale price?
The most common method used by an investor to determine a fair sale price is a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) — a measure of a business's ability to generate operating earnings. Future EBITDA is what is available to future owners to recover their investment or purchase price.
- The multiple varies by industry, business size, market conditions, goodwill, intellectual property, location, management team, customers and other qualitative elements — many variables influence the multiple a buyer can justify
- After arriving at the EBITDA-based figure, an expert also calculates the value of tangible and intangible assets and considers what comparable businesses have sold for
- If different valuation approaches yield different outcomes, the expert investigates what caused the differences and may adjust the EBITDA multiple
- An expert's judgment, experience, market-based information and estimates are all involved
Why does valuation matter to your net worth?
Because of the complexity and high stakes — a business may represent as much as 80% of an owner's net worth — it is smart to hire experienced professionals to help you understand the value, set a price, judge whether a buyer's offer is reasonable, and advise how valuation options change your tax liability and how to minimize tax and other personal liabilities in a full or partial sale. Experts on your team bring collective legal, financial, tax and deal-doing experience, access to industry data, accepted financial formulas and proprietary resources to arrive at a value range based on current competitive conditions and your company's future performance.
What additional benefits come from the valuation process?
- Understanding strengths and addressing weaknesses — the assessment process may uncover weaknesses in your organization, letting you decide, define, address and proactively time an eventual transaction after fixing those weaknesses to maximize current growth and the eventual transaction price
- Could your business be more than one business? — your business may be more valuable in pieces; for example, a real-estate buyer may find your real-estate holdings more attractive as an asset than the operating business that occupies them, while a business buyer may find the real estate distracting because its ownership is not necessary to ongoing operations
- Creating a premium valuation — value can be substantially increased through a professional M&A auction process; a single buyer you engage directly, often under their terms and timing, will typically pay less than competing buyers brought into a professional process led by your M&A advisors, because a competitive auction drives valuations beyond what financial formulas alone would suggest
Key facts: why entrepreneurs overestimate business value
Endowment effect: owners attach higher value to what they own (Harvard Business Review)
First step: recognize your own valuation bias; buyers and third parties value differently
Primary method: a multiple of EBITDA, adjusted by industry, size, goodwill, IP, management and other factors
Cross-checks: tangible/intangible asset values and comparable transactions
Net worth stakes: a business may represent up to 80% of an owner's net worth
Process benefits: uncovers weaknesses to fix, reveals whether the business is worth more in pieces, and supports a premium valuation through a competitive auction
Disclaimer: This article is for general informational purposes only and does not constitute valuation, legal, tax or financial advice. Consult a qualified business valuator and your advisors regarding your specific circumstances.
