Selling a Business: The Problem of Overvaluation
His thought process went something like this: “I’ve built this business over 30 years so it must be worth a lot of money. A couple of years ago we built a nice place to retire to and need to clear the mortgage. We also need a couple of million to create a pension pot that will maintain our lifestyle. The business has provided us a very nice lifestyle and will do the same for the new owners – it has to be worth about $3 million.”
It’s difficult to be objective about something you’ve built from the ground up; a business that has shaped your life and underpins your standing in the community. Coincidentally, $3 million happened to be about the figure he needed to meet his retirement aspirations.
It comes as a shock to a lot of business owners, but the value of their business is fundamentally about the cash flow it generates. In this case the business generated $250 thousand cash flow to the owners, had $500,000 thousand of working capital and freehold real estate worth another $500,000. I valued the business at about $1.5 million. This was a genuine shock for the owner.
Needless to say, I did not get the contract to sell for this owner. The business is now listed with another broker at $3 million. Presumably, this broker believes he can manage the client’s expectations when the business has been on the market a few months. Unfortunately, some brokers do overvalue businesses because that’s what the seller wants to hear, and to improve their prospects of securing the sale.
A seller might well think that trying an unrealistic price to start with does no harm – but that is far from the truth. We recently took a contract to sell a business that had been on the market for two years with another broker at $1.5 million. On a good day it was really worth about $750 thousand and the owner had come to realize that. Unfortunately, he had already turned down two offers at that level. As we began to market the company it became clear that the previous asking price hung around the business like a bad smell. It takes a lot of effort and expense to buy a business and credible buyers were reluctant to get involved. They felt the seller still had his heart set on the higher price, and when it came to the crunch might decide not to sell – so why waste their own time and money?
So how as a seller do you make a realistic decision about the value of a business? As a starting point remember that a broker has nothing to gain by putting forward a low valuation. It’s likely to be an honest appraisal based on information provided, and knowledge of the market. My advice is to meet with two or three brokers and listen carefully to what they have to say. They will be far more objective than you could possibly manage. Ask each broker to put his valuation in writing, with an explanation of how he arrived at the suggested figure.
Remember, when it gets down to the nuts and bolts, the value of a business is based on the income it will generate for the new owners and the potential they see for growth. It has nothing to do with the number of years you have spent building the business. Sentiment just doesn’t factor into it.