How to prevent or close deal-breaking valuation gaps
Whether a company is a Main Street florist or Fortune 100, executives and owners struggle with the gap between their perceived value of the business and the market value. In fact, this valuation gap is the top reason private-company transactions fail to close, according to the 2017 Private Capital Markets Report by Pepperdine University. For more than half of the deals that flopped in 2016 due to a gap in pricing, the difference was at least 20 percent.
For more than half of the deals that flopped in 2016 due to a gap in pricing, the difference was at least 20 percent.
Discrepancies between what a buyer is willing to pay and what a business owner expects or needs to get out of the business can have multiple causes, and not all of them are avoidable. However, advisors and accountants who perform valuations can take a number of steps to help bridge valuation gaps and to help their clients.
Talk about the business’s plans for the future
Preventing valuation gaps can first be addressed by asking business clients about their plans for the future. It’s a simple question that ought to be asked more frequently. About 1 in every 3 family firms has no succession plan at all, and fewer than 1 in every 4 has a plan that is actually in writing and has been communicated to the firm’s key stakeholders, according to a recent survey of private companies by PwC. With little-to-no exit planning in place, these firms have no assurance that they will be able to get out of the business what they want or need for retirement or the next stage in business. Finding this out after the owner decides it is time to exit can be devastating, financially and personally.
Simply asking business owners questions such as, “How much attention have you given to your transition plan?” or “What do you want to accomplish with the transfer of your business?” can start the process of educating them about what goes into valuing a business. This questioning can also lead to discussions about how the value could differ dramatically from their current expectations or the values they have heard from friends who sold a business. Asking business owners open-ended questions can help the firm win valuation engagements, which is a common challenge among firms.
Bridge valuation gaps by talking often about valuation, not just when time to sell
Another approach to bridging valuation gaps before the sales process is to talk frequently with a business owner about how to increase the intrinsic value of the business. Business owners might associate valuations only with a business sale or acquisition, but valuation experts can teach owners that the process of arriving at the appropriate value of the business can reveal opportunities to ensure the business is sustainable or to prepare for an eventual sale, even if it is years away. Most business owners desire to grow, but they often acknowledge lacking the people, money or strategy to do so.
Utilize valuation software to objectively develop values
Some advisory professionals utilize valuation software that values the subject company using the income, market or asset approaches, depending on the owner’s objectives, to help owners understand what influences business value. Users can illustrate to owners how the numbers might vary based on the objectives and the assumptions feeding into the process (e.g., cost structure, revenue sources and cost of capital). Using a robust, integrated industry database to benchmark financial performance against similar businesses can also demonstrate to owners why what they heard a friend received for a business might differ from their own valuation when the time comes to sell – and what they can do to address any red flags.
Why it matters
Minimizing or closing gaps among the expected business values of buyers and sellers is likely to become increasingly important. Many brokers expect deal flow to increase in the coming months, based on the Pepperdine survey. In addition, the PwC survey found that more business owners are expecting to sell their businesses outright than to pass the baton on to another family member.
Indeed, The Exit Planning Institute estimates that some 4.5 million firms representing more than $10 trillion in business value will transition over the next decade or so – an extraordinary level of opportunity for those advising or valuating businesses.
Some 4.5 million firms representing more than $10 trillion in business value will transition over the next decade or so
–The Exit Planning Institute
At the same time, however, a first-quarter “Market Pulse” survey by Pepperdine, the International Business Brokers Association and M&A Source found that many business brokers and M&A advisors predict a decrease in valuations and a smaller buyer pool by the end of the year. Those polled also expect rising interest rates will make it harder to finance transactions. These trends reinforce the need for business owners to understand the factors that can lead to a disappointing price or worse yet, to no sale at all.
For more advice on helping business owners understand the impact their actions have on business value goals, listen to a free on-demand webinar hosted by Sageworks: “The Five Stages of Value: How to Maximize Business Value & Unlock Trapped Wealth”
Practice Aid: Why Do Business Owners Need a Valuation?
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