Company Valuation: Entrepreneur vs. Buyer – The Game of 3 Biases and The 4 Valuations

The business owner’s idea of valuation is very different than the buyer’s view of valuation because business owners usually insist that their business is worth much more than what it’s actually worth. This can create a problem when the business owner goes to sell their company.

Let’s talk why.

There are four biases that make the business owner emotional and unrealistic about their company value.

  1. It’s likely the business owner has 80% to 90% or more of their net worth invested in their company.
  2. The business owner and their loved ones have sacrificed dearly to make the business a success.
  3. The business supports the business owner’s lifestyle and related perks.
  4. Optimism–this is a classic case of drinking too much of your own kool-aid. Business owners are passionate and optimistic which in the case of their business valuation can be to their detriment, in some cases.

All these biases and the buyer’s perspective lead to four different types of valuations.

The first is Sacrifice Valuation. Business owners expect a high price for their company because they have sacrificed and prioritized the needs of their company ahead of their own. It’s not much different than if you remodelled your own house by yourself taking care of every little detail and as a result you expect a significant chunk above market because of your personal bias.

The second valuation is what we call E-Math, or entrepreneur math. This is where the business owner takes the sale proceeds and then applies an interest rate to determine their annual income after selling.

Let’s take an example. Let’s say you’re making a million dollars a year in profits, and you sell your company for a 5X multiple of profits, i.e. 5 million dollars. Let’s also say that your taxes and debt come out to 2 million dollars. Your net take home investable cash is 3 million dollars which at a 4% interest rate provides $120,000 dollars a year, before taxes. All of a sudden, you as a business owner are in a position where you go from making a million dollars a year to making $120,000 a year. Since the income gap is so wide, assessing business value using this math  creates a heck of a disconnect with the market reality of your business value.

Annual Income Before Sale: $1,000,000

Multiple:  5X

Purchase Price: $5,000,000

Taxes & Debt: $2,000,000

Net Take Home Investable Cash $3,000,000

Entrepreneur’s Investment Income

After Sale @ 4% Interest:   $120,000

The third valuation is the Opportunity Valuation. Most business owners are very passionate about their companies and bullish about the future and love to talk in percentages, so they will say things like “ If we just get 3 percent of the market, this will be a billion dollar company.” However, the buyer has a more objective lens and is not just looking at the market opportunity, but also the company’s actual capacity to harvest the opportunity.

Which leads to Valuation 4, which is the Buyer’s Valuation. It uses a classic formula which divides benefit over risk to make a valuation decision. They generally look to get the highest benefit versus the lowest risk. And if the risk is very high, they’re likely to walk away or ask for very onerous transaction terms.

Value = Benefit/Risk

So, here is the punchline. It takes optimism to be a business owner, but it takes realism to sell a business. Whether you’re ready to sell now or have a long-term horizon, it’s best to take a hard look at your business. The same sort of hard look your potential buyers will be taking one day. You should work with a competent advisor to determine a realistic valuation range of your business before even contemplating a sale. This will greatly minimize surprises and improve the outcome.

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