By: Patrick Ungashick
When do you need to get a business valuation?
Many exit planning books, websites, and advisors recommend getting a business valuation as one of the first steps in exit planning, if not the very first step. At NAVIX, we disagree. While business valuations are a critically important tool in certain situations, business owners should not rush into getting a valuation without careful consideration. The following six misconceptions explain why.
A business valuation reveals what your company will be worth at sale.
Unfortunately, the only way to know what your company is worth at sale is to enter the market and see what potential buyers are willing to pay for it. While an appraisal by a valuation professional might produce a figure that is close to what some buyers might pay, not all buyers are the same. Buyers have different needs, interests, resources, and potential synergies. This is why it is not unusual to receive a wide range of offer prices when multiple buyers are bidding on the same company. A business valuation cannot anticipate every buyer’s motives and therefore cannot be expected to forecast a company’s final selling price.
Business owners should get a business valuation at the beginning of their exit planning.
Getting a valuation at the start of one’s exit planning is unnecessary most of the time and might even be potentially harmful. At the start of your exit planning, you might not yet know if you need your valuation to aim high or low. What a business is worth is in part subjective. If you ultimately decide to pursue selling your business to an outside buyer, you hope and aim for a high potential price. But what if you decide to give the business to your children? If that proves to be your exit strategy, you will want an appraisal to aim for the lowest reasonable company value. To further complicate matters, if your exit strategy is to sell to an inside buyer (one or more employees), then depending on the circumstances the desired value could be high or low. Even if you believe that you know your exit strategy at the start, it’s not uncommon for owners to later change their exit strategy once they dig deeper into the exit planning process.
Getting a valuation right at the start of your exit planning is usually premature. You may waste time and money getting a valuation that aims in the wrong direction, and unfortunately once acquired, you cannot make the valuation just go away. Somebody, such as the IRS, may later ask to see that valuation and you might regret what it says.
Having a business valuation will help you negotiate a higher price.
If, while attempting to sell your company, you find yourself negotiating with a buyer whose offer price is lower than your liking, you could try to get the potential buyer to increase its offer price by producing a third-party valuation that assigns a higher value than the initial offer. However, this tactic is unlikely to create much leverage for you. Most buyers will feel little pressure to raise their purchase price because the valuation comes from a third-party without a vested interest. A superior way to create leverage is to have multiple buyers competing to acquire your company, so that a bidding war ensues. Competition maximizes your leverage.
Business valuations used for one purpose can be relied upon for another purpose.
Recently, a business owner whose company is partially owned by an ESOP (employee stock ownership plan) found himself in the midst of a divorce. ESOP companies are required by law to have an annual business valuation. This company’s most recent valuation calculated a total value of $10 million. The owner assumed that $10 million would be the value upon which his divorce would be settled. However, things became contentious and the divorcing couple ended up court. The divorce court ordered a new valuation, which came in at more than $30 million to the owner’s shock and dismay.
There are different methods to value a company, any one of which can produce a greatly different figure. For example, a privately-owned company’s value could be calculated based on its future earnings potential, its comparable market transactions, or its assets—or some combination of these three methods. Furthermore, valuations grow stale with time. A valuation done as recently as six months to a year earlier might be irrelevant if business or external conditions have changed. If a valuation was acquired for one purpose, it cannot be assumed that the valuation will be applicable or respected in other situations.
Use a business valuation to keep score on how your company is performing.
We see this suggestion often. The idea is to get a valuation once a year (or sometimes even more often) to track and evaluate the company’s growth and the performance of its leadership team in particular. In fairness, publicly-traded companies are able to rely on this strategy because the stock market provides constant feedback on the company’s progress and value.
With privately-held companies, however, this tactic has two problems. First, as stated in Misconception #2 above, depending on your ultimate exit strategy you may later regret having on record those valuations stating the company is worth $XX amount. Second, in most situations this simply wastes money when a free alternative exists. All privately-held companies can and should track the key operational, sales, and financial metrics that drive healthy business growth. These metrics can be summarized on a dashboard to provide accurate and timely feedback on business progress and leadership team performance. This not only saves you the cost of a valuation but also provides leadership teams with an actionable tool for tracking performance.
If a valuation is needed, you should hire the appraiser.
There are valid and important reasons to get a formal business valuation. Three of the more common reasons are:
- It is required for regulatory compliance (such as with ESOPs).
- You are doing important tax planning that requires establishing a business value.
- You are seeking to minimize or resolve contention between interested parties such as spouses or business co-owners.
If facing one of these situations, getting a business valuation is prudent and usually necessary. However, do not hire the valuation professional on your own. Speak with your legal advisors first. It may be beneficial to have your attorney hire the valuation professional and receive the appraisal on your behalf. When having a valuation done, it’s impossible to predict the outcome. The final number may be what you expected, or it might come in significantly higher or lower than desired. If your attorney commissions the appraisal, the valuation’s findings may be protected by attorney-client confidentiality, meaning you will not have to disclose its results to an outside party. Again, it’s important to consult your attorney on these issues.
In summary, business valuations are an important tool in the exit planning process but should not be your first step. Before getting a valuation, owners should clearly define their exit goals and plans. Then, owners can work with their tax, legal, and exit advisors to determine if a valuation is needed and the best course of action to follow.