Vercor - Business Valuation: Confusing and Misunderstood

Business Valuation: Confusing and Misunderstood

Do you want to know the value of your business? Pose the question to your closest friends and advisors. You will be amazed at the range of responses. For further amusement, ask each how they arrived at their answer.

Despite the fact that value and valuation is foundational to our entire economic lives and free-market system, the concepts remain misunderstood and are constantly misapplied. It can be said that only a precious few possess a true working knowledge of valuation. From these few come the capitalists that earn ninety-nine percent of the wealth today. They do so by combining their knowledge with risk capital and putting both to work. They are the ones on the front pages of our newspapers and financial journals.

There should be little wonder why valuation is shrouded in confusion. Our high schools and colleges don’t teach it (outside basic microeconomic theory). Contrary to common belief, the basic curriculum for accountants and attorneys do not include business valuation. Most graduate business schools only cover the valuation of publicly traded securities. In addition, many would be surprised to find that bankers are not trained in business valuation, and almost never look at business value when assessing a loan.

Unfortunately, business valuation has some inherent characteristics that foster confusion and misinformation, such as:

Value is Subjective: Valuation is not exact, but rather subjective. Like beauty, value is ”in the eyes of the beholder”. What is the value of the watch on your hand? Or the diamond ring your spouse gave you? Or what about your father’s prized possession – an old 1971 Lincoln Continental that has been parked, unprotected in your backyard for the past eight years?

Few People, Even Business People, are Exposed to Factual Business Sale Data: The fact so few of us own businesses means few experience the purchase or sale of a business first hand. Businesses are not bought and sold as frequently as real estate or cars. When businesses are sold, the sale data is much more complex and usually protected as confidential. Conversely, real estate sale data is of public record and is automatically recorded, typically at the county government level.

High Interest and Little Factual Data Breeds Misinformation: For whatever reason, people in our culture are immensely interested in both people and money. Business sale transactions involve people and often, a lot of money. Therefore, there is much interest in the terms of sale. Combined with the fact business sale data is not typically made available, misinformation quickly fills the void. This phenomenon is well documented in research studies. Plus, the buyer or seller may allow or even seed false data, putting him or her in a favorable light.

Complexity of Business Sale Transactions, and Prevalence of “Terms”: Unlike cars and houses, businesses usually do not sell for 100 percent cash at closing. It is very common for the price to ultimately be contingent on certain events occurring after the date of sale. The portion of a purchase price not paid at closing is referred to as “terms”. As such, the actual sale price is often very difficult to determine. In these cases, the actual sale price can only be determined after all contingent events occur and the “terms” payments are calculated and paid.

Each Business is One-of-a-Kind: Most things we buy have identical or close substitutes. Even a used car or most houses can be considered to have very close substitutes. This makes the task of valuing much easier because we can compare it to others with similar characteristics. In contrast, businesses are most always unique, rarely having close substitutes. Therefore, applying the “comparable sales” method is much more challenging.

Finally, the cout d’ gras of confusion, “what is the value?”, has no definite answer unless the business is actually sold, and sold in a certain manner. Since the valuation task is often separate from an actual sale, value can only be estimated. In fact, this is precisely the valuation task. Nevertheless, to do so we must first answer three important questions: 1) value to whom? 2) what definition of value? and 3) value as of what date?

This article was written by David L. Perkins, Jr. He is a VERCOR partner, M&A Consultant, business appraiser and editor and publisher of the national newsletter titled The Business Owner.

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