What is a business really worth? The answer isn't always one number.
My new book, Business and Asset Values, is designed for business owners, buyers, sellers, lenders, accountants, lawyers, advisors, and anyone who wants to better understand how businesses and their assets are valued.
In this video, I introduce the ideas behind the book, including fair market value, liquidation value, business valuation methods, SDE and EBITDA, cash flow, debt, working capital, goodwill, transferability, and why buyers and sellers can look at the same business and reasonably reach different conclusions about its value.
Outbid by Private Equity? 7 Questions to Ask Before You Pay More for a Business
You find a good small business. You analyze the numbers, decide what you can reasonably pay, and make an offer.
Then another buyer—maybe a private equity group—comes along and offers substantially more.
Did you lose?
Not necessarily.
The collapse of Renovo Home Partners provides a useful lesson about what can happen when acquisition prices, leverage, operational assumptions, and market conditions combine to create a fragile business.
Renovo was a private equity-backed roll-up of home improvement businesses. Public reporting described a network that eventually included 16 affiliated subsidiaries operating in at least nine states. The business ultimately entered Chapter 7 bankruptcy, leaving employees, customers, lenders, and other creditors dealing with the consequences. Pasted text
We don't have enough public information to know precisely what caused Renovo's failure. But the case provides a useful framework for any small-business buyer who finds themselves competing against an aggressive bidder.
Why Can Private Equity Pay More for a Small Business?
A roll-up typically involves acquiring several similar companies with the expectation that the combined organization will become more valuable and efficient.
The buyer might expect centralized marketing, purchasing power, shared management, consolidated customer service, better financing processes, or other economies of scale.
In other words, they're not necessarily valuing the company based only on what it is today.
They're also valuing their plan for what it could become.
That can support a higher offer—but only if those assumptions actually work.
“Being the highest bidder sometimes just means that you're assuming the rosiest future.”
Individual buyers make the same mistake. They justify a price based on improvements they expect to make after closing: new software, better marketing, improved management, higher prices, lower expenses, or some other supposed efficiency.
Those improvements may happen.
But you shouldn't confuse something you hope to create with something you're buying from the seller.
1. What Happens If Revenue Drops 15% to 25%?
Stress-test the acquisition before worrying about whether somebody else will outbid you.
What happens if sales fall?
Small-business revenue doesn't necessarily move upward in a straight line. A highly leveraged acquisition can become extremely uncomfortable after a relatively ordinary decline in sales.
Debt payments remain.
Equipment still needs maintenance.
Employees still need to be paid.
If a 15% decline means you can no longer pay yourself, reinvest in the company, or comfortably service the acquisition debt, you need to understand that before closing.
2. Does the Business Depend on Customers Getting Financing?
Some businesses have derivative exposure to credit conditions.
A home improvement contractor, automobile-related business, or seller of other expensive products may depend on customers obtaining financing.
The company itself doesn't have to lose access to credit for this to become a problem. Its customers can lose access.
That introduces a risk controlled partly by lenders, interest rates, household finances, and broader economic conditions.
The same principle applies to acquisition structures involving balloon payments.
You shouldn't casually assume that because refinancing is available now, you'll qualify for it several years from now.
3. Are the Supposed Synergies Actually Realistic?
A roll-up strategy often assumes efficiencies from combining businesses.
But businesses operating in different locations may face different regulations, licensing requirements, payment practices, labor markets, customer expectations, and competitive conditions.
Centralizing something doesn't automatically make it more efficient.
If you're evaluating an acquisition because you believe you can make substantial operational improvements, ask specifically:
What am I going to change, how much will it cost, how long will it take, and what evidence suggests the improvement is achievable?
4. How Much Customer Deposit Liability Is on the Balance Sheet?
This is particularly important for contractors and other businesses that collect deposits before completing work.
A customer deposit isn't necessarily revenue.
“When you take a deposit from someone, it should appear on your balance sheet as a liability. You're borrowing money from your customer.”
That distinction matters enormously when determining the working capital requirements of a business.
Poor bookkeeping can make it difficult for a buyer to understand how much work remains to be performed against money already collected.
You need to understand not just the company's assets, but the economic obligations attached to the money sitting in the business.
5. How Founder-Dependent Is the Business?
Founder dependency isn't limited to customer relationships.
In a skilled trade, the owner's relationship with employees may be just as important.
Maybe the foremen were trained by the owner. Maybe experienced technicians remain because of personal loyalty. Maybe the seller is the person holding the team together.
If those people leave after the acquisition, your ability to deliver the company's product or service can disappear remarkably quickly.
Ask what the owner actually does—and what could leave with them.
6. What Is the Integration Plan?
If your valuation depends on integrating the acquisition into another operation, the integration plan needs to be more than a spreadsheet assumption.
Think through systems, employees, brands, suppliers, management, customer service, accounting, marketing, and operational processes.
Which systems will change?
Who will manage the transition?
What will it cost?
How long will it take?
What happens if integration takes twice as long as expected?
The more things that have to go right simultaneously, the more fragile the transaction becomes.
7. Are You Buying a Business—or Gambling on Your Forecast?
This is the most important question.
A buyer's goal should not be to win an auction.
I learned this lesson in a much more literal auction when my son was young. He wanted me to keep raising my paddle because he wanted us to “win” the item being auctioned.
I had stopped because the price had already gone beyond what I was prepared to pay.
My answer to him was simple:
“We're not winning if we pay too much.”
The exact same principle applies when buying a business.
Private equity may have access to more leverage, investor capital, or transaction structures unavailable to an individual buyer. That doesn't mean you should imitate their economics.
An individual buyer may also personally guarantee substantial acquisition debt. That makes an overly optimistic transaction particularly dangerous.
Your advantage isn't necessarily access to the most leverage.
Your advantages can be focus, discipline, industry knowledge, operational experience, and the willingness to walk away.
Getting Outbid Doesn't Mean You Lost
One of the hardest things about searching for a business is spending months investigating an opportunity only to see somebody else offer more.
The natural response is to ask, “How can I compete?”
Sometimes you shouldn't.
A higher-priced offer may include contingencies, seller financing, equity rollovers, or other terms that make the headline price less straightforward than it appears.
In other situations, another buyer simply may be prepared to take risks you aren't willing to take.
“If you get outbid by private equity, don't assume that you lost. You may have just avoided inheriting a time bomb.”
Buying an existing business is supposed to give you advantages over starting from zero.
If you overpay, maximize leverage, and create a company that can only survive when every assumption goes right, you can eliminate those advantages yourself.
Discipline isn't losing the deal.
Sometimes it's the thing that keeps you available for the next one.
Want Help Analyzing a Business Before You Buy?
If you're evaluating a business and need help understanding the financials, risks, financing, valuation, or potential deal structure, ALP's Business Investment Analysis services can help you examine the opportunity before committing to the transaction.
Learn more by signing up to our Business Buyer Advantage: Online Training, including the new bonus module at www.BusinessBuyerAdvantage.com
How Much Is Your Small Business Worth? Why the Purpose of the Valuation Matters
“How much is my business worth?”
It sounds like a straightforward question. Many business owners expect there should be a formula: enter the earnings, apply the correct multiple, and get the answer.
Unfortunately, small-business valuation doesn't work that way.
A business can legitimately receive very different valuations depending on why it is being valued, who is doing the valuation, what assumptions are being made, and what the resulting number is supposed to represent.
That's particularly important for an owner planning an exit. A technically sophisticated valuation isn't necessarily the same thing as a realistic estimate of what an outside buyer might actually pay for the business.
What Is the Valuation Actually For?
Before hiring someone to value a business, determine the purpose.
A valuation might be required for:
A business sale
A business acquisition
Tax planning or transferring shares
A shareholder dispute
Divorce or other legal proceedings
Investment purposes
Retirement and exit planning
Different purposes can require different methodologies.
For example, valuing a minority shareholding for tax or legal purposes can involve questions about control and discounts. A court-related valuation may require a credentialed professional capable of defending the methodology.
But an owner asking, “What could I realistically sell my business for?” is asking a different question.
For that purpose, we use what we call a Most Probable Selling Price (MPSP) evaluation.
The objective isn't to produce the largest theoretical number. It's to estimate what an outside buyer might reasonably pay in an actual transaction.
Buyers Really Want Answers to Two Questions
When someone evaluates a small business for acquisition, there are two fundamental questions:
“What is the cash flow?”
And then:
“Will the cash flow continue after I become an owner?”
The first question helps determine what a buyer might be willing and able to pay.
The second can determine whether they're willing to buy the business at all.
That's why valuation cannot be reduced to multiplying earnings by a number.
A buyer also needs to understand customer concentration, systems and processes, owner dependency, employee relationships, competitive position, and where the goodwill of the business actually resides.
If most of the goodwill resides personally with the owner, for example, the historical cash flow may become less valuable to a buyer who isn't certain it will survive the transition.
Why You Can't Just Average Comparable Business Sales
Actual transaction data can be extremely useful.
If you're valuing a restaurant, for example, you can look at sales of other restaurants and examine what buyers have historically paid.
But you have to interpret the data.
Imagine finding a small café that sold for five or six times Seller's Discretionary Earnings (SDE). At first glance, you might conclude that comparable cafés deserve a five- or six-times multiple.
Then you discover the café generated only $13,000 of SDE.
What probably drove the transaction?
The espresso machine, refrigerators, counters, furniture, fixtures, and other assets may have been worth enough that the resulting sale price merely happened to equal five or six times SDE.
Simply averaging transaction multiples can therefore produce misleading conclusions.
As I often remind people, business valuation is not a cookie-cutter exercise.
Can a Valuation Be Mathematically Correct but Still Wrong for Your Purpose?
Absolutely.
A spreadsheet can contain perfectly correct mathematics and still produce a number that isn't useful for the question you're trying to answer.
I encountered this with a restaurant owner whose accountant had completed extensive valuation work and concluded that the business was worth approximately $1.6 million to $1.65 million.
When we normalized the financial statements for an MPSP evaluation, we calculated approximately $230,000 in SDE.
Our estimate of the most probable selling price was approximately $571,000.
That's an enormous difference.
It doesn't necessarily mean somebody couldn't create a methodology that mathematically supported the higher number. The problem was whether an outside buyer in the small-business marketplace would actually pay it.
That distinction becomes critical when the owner is building a retirement plan around the expected proceeds from selling the business. Pasted text
Be Careful About Valuations Based on Future Growth
Another situation involved a buyer examining a company that sold and installed materials used in housing.
We calculated approximately $113,000 in SDE based on the company's current performance. Even if the business returned to previous performance levels, we estimated SDE would be approximately $242,000.
The seller had received a discounted cash flow valuation estimating enterprise value at approximately $1.5 million.
The mathematics wasn't necessarily the problem.
The assumptions were.
The valuation assumed substantial future revenue growth while cost of goods sold and overhead remained relatively constant.
For a small owner-operated business, there's another problem with paying for projected growth.
“If you think you can grow the business, why would you make that growth part of what you pay the seller?”
If the buyer will be doing the work required to generate future growth, the buyer will generally want the purchase price to reflect what the seller has already built—not all the improvements the buyer hopes to create afterward.
That's why forward-looking analysis in an MPSP evaluation is generally limited. When appropriate, current year-to-date performance might support a forecast of the current year, but that is very different from pricing years of assumed future growth into today's valuation.
Why an Unrealistic Valuation Can Damage Your Exit Plan
An inflated valuation doesn't just create disappointment when you eventually list the business.
It can distort years of financial planning.
If you've been told your company is worth $1.6 million, you may start planning your retirement as though $1.6 million will eventually become available.
But if the actual market of qualified buyers is closer to $600,000, your retirement plan has a major hole in it.
That's why owners should investigate probable selling price years before they intend to sell.
Discovering a valuation problem early gives you time to do something about it.
How Can You Increase the Value of Your Business Before Selling?
An early MPSP evaluation can identify areas that may make the business more attractive to buyers.
One tool we use is a Locus of Goodwill analysis, which looks at whether goodwill resides primarily with the owner, the company's brand, or its location.
Benchmarking can also identify operating improvements.
Suppose your gross margin is two percentage points below comparable businesses in your industry.
If you can improve purchasing, bidding, or pricing and permanently increase gross margin by two percentage points, that additional profit can flow to the bottom line.
Now apply an appropriate valuation multiple to the improved cash flow.
You've potentially increased the value of the company while also enjoying greater profitability during the remaining years you own it.
The Best Time to Learn What Your Business May Sell For Is Before You Need to Sell
Most small-business owners are experts at operating their businesses.
They're not necessarily experts at selling them.
That distinction matters.
If you're planning an exit, don't begin with the question, “Who can give me the highest valuation?”
Begin with:
“What type of valuation answers the question I actually need answered?”
If the goal is to sell the business to an outside buyer, you need to understand the cash flow a buyer will recognize, whether that cash flow is transferable, what comparable transactions indicate, and what deal would realistically make economic sense for someone on the other side of the table.
Knowing that several years before your exit gives you something even more valuable than a number.
It gives you time to improve it.
Find Out What Your Business Could Realistically Sell For
If you're considering selling your business now or planning an exit several years from now, David and the ALP team offer Most Probable Selling Price evaluations as part of their seller and exit-planning services.
The process can help you understand normalized cash flow, probable selling price, where the goodwill resides in your business, and areas you may be able to improve before going to market.
