Quick show of hands- how many people will immediately take the word of a person who they do not know well that an item that the person is selling is worth what s/he says that it is?
For those of you who raised your hands, you can own a great valuation firm today for the very reasonable sum of… oh…. $16 million.
And I’ll even finance the deal for you, no interest involved- how’s $800,000 a year for the next 20 years sound?
For the 99.9% of you with your hands still by your sides, you know that it is probably a good idea to have the price of whatever asset you’re contemplating purchasing independently verified, by whatever means appropriate. If it’s a relatively minor purchase, you might have the price verified through a quick on-line search; for a more complex asset, you probably want to go to greater lengths to have that price verified.
If the asset that you are purchasing is a business, you are doing yourself a huge disservice if you take the word of the person selling the business that the business is worth what they say it is.
I was recently approached by an entrepreneur who had the opportunity to purchase a small business. The price that was quoted to her was $150k, and she did the right thing by asking me to independently verify that price. Turns out that the business was worth closer to $74,000- A FAR CRY from the original asking price. Smart business move on my client’s part- the cost of a valuation engagement saved her over $75,000.
How does this happen, anyway? Two main reasons:
- The business owner who started his/her own business has so much blood, sweat, and tears invested into it, that the “halo effect” kicks in, and the business takes on way more value in the eyes of the business owner than an objective appraiser might impute.You might call it the “ugly baby” syndrome- no-one’s baby is ugly in their own eyes, and no business owner thinks that their business is not worth a lot of money.
- There is obviously a legitimate reason why the seller of a business would like for it to be valued higher than it is truly worth- that person gets more money than they should after the transaction is complete. So information that might bring down the value of a business might be implicitly (or explicitly) de-emphasized, and information that might raise the value might be heavily emphasized. You might argue that that’s a normal human reaction; I would argue that this puts the business owner in a biased position, where they are not able to see the business in an objective light.
So the moral of the story is simple- even if the seller of a business is not being dishonest, there are always built-in factors that prevent him/her from being able to be objective about the value of the business. So if you are in the market for a business and have one in your sights, do the smart thing and have an independent entity “kick the tires” for you; you might save yourself $76,000 (or $16 million).
Next week, we will look at the fallacy of using common “multiples” to value a target business.