The Tragedy of a Poorly-Executed Business Valuation

A poorly-executed business valuation can have tragic impacts on business owners.

At an alarming rate, we have been encountering small business owners who have been given unrealistic valuation guidance from trusted advisors and professional firms. This unfortunately sets the owner up for massive disappointment and potentially harmful decision-making in one of the most significant events of their lives.

Small (for example, $10M in revenue and below) business owners that want to sell and retire naturally want to understand the value of their company. Most of these business owners want to know the truth. We stress “most” because there is a certain segment that refuses to accept that valuation is based on return on investment (ROI) and not on reputation and potential. 

These small business owners often find or are referred to advisory firms that do not sell businesses and/or are accustomed to working exclusively on middle market+ sized transactions ($100M+ enterprise value). Now, we are not condemning industry professionals at all; there are many very high-quality firms and analysts that think deeply about the owners’ goals and apply the appropriate methods and resources to the valuation exercise. However, there are many that do not. They often assign smaller clients to junior analysts who use the resources provided to them combined with theoretical nonsense to reach conclusions that have no bearing in reality. Since these firms do not need to and do not have any practical experience delivering on their valuation number, it is sadly true that they simply do not understand the data that will be relevant when actually selling said business.

Here is a story, an example of what we run into frequently. 

We were recently introduced to the owner of an interior design/home furnishings business. The partners wanted to sell the business and had a valuation done for the business by a large firm that touted its work for the big four accounting firms and billion-dollar transactions. 

This company’s sales were ~$1.2 million and the adjusted EBITDA* calculation calculated by the valuation firm was ~$250K for the most recent year. The business has 6 employees.

For the Market Method, whereby comparable transactions are sought out, the analyst pulled 7 comps from CapIQ, a database of largely publicly-traded companies. The valuations of the “comparable” companies were the following: 

Recall that the target company’s revenue was $1.2 million. The revenue of the smallest “comparable” utilized was $700M, or 583x larger than the target company. This is akin to comparing a 1-man machine shop run out of a pole barn to a $100M production manufacturing business with an international customer base. Other than the fact they employ at least one person, nothing is comparable about these companies. 

The mean EBITDA range determined by the analyst was 6.5x-7.0x EBITDA. The analyst proceeded to concoct fairy tales with a number of additional exhibits in their valuation process. They used billion-dollar publicly-traded company metrics to build an income method model. They also used revenue multiplier comps, which no buyer or lender would do. The analyst claimed that there weren’t enough smaller private company comparables available to use, which is false (we found 23 in less than 10 minutes). It was also determined that three active full-time owners making a combined $225K in salary could be replaced by one manager making $75K. Ultimately, their valuation conclusion was $1.6M – $1.8M.

Now, we do not know the actual appropriate range because we have not done the valuation ourselves or had access to the appropriate financial information. We have been around the block enough to know that the adjusted EBITDA has likely been inflated by a minimum of $100-$125K and the multiples for a company with $125-150K in adjusted EBITDA are closer to 2.0x.

This is a tragedy. Three owners who have likely lived a fine life but have not made a fortune have been told that they may achieve $1.6-1.8M for their business when the truth is that it’s much more likely to be $250-350K. That is a significant difference. That is retirement plans, livelihoods, vacation homes, and travel plans upended. All due to a financial advisor, a trusted professional, either not having the proper training/resources or worse, preferring to illustrate an improbable outcome with fancy reports rather than breaking down the hard truth.

Furthermore, once a valuation has been presented, it tends to serve as a psychological anchor for a business owner. When there is a vast divergence between the anchor and reality, it often results in the sale process taking an excessive amount of time or never happening at all because the owner struggles so much with reconciling what someone told them their business was worth versus the often harsh reality of the market.

If you were training to be a pilot and had a choice between instructors, one who had studied aviation but had never flown a plane, or one that flew around the world 40 times a year successfully, who would you feel better about choosing?

Before you fly your plane into the sunset, make sure you have an experienced mechanic, pilot, and flight crew by your side.

If you are interested in a conservative, well-researched, understandable, and reasonably-priced business valuation delivered by a team of experts who must stand behind their work on the marketplace, please contact Calder confidentially.

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*EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. By stripping out the non-cash depreciation and amortization expense as well as taxes and debt costs dependent on the capital structure, EBITDA attempts to represent cash profit generated by the company’s operations. EBITDA is widely used as a key component when calculating business valuation.