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5 Business Valuation Mistakes to Avoid When Selling Your Company

Updated: Jan 5, 2022

Valuing a private business is more art than science and mistakes are often made. The most common approach to valuing a small or medium sized business is using a multiple of adjusted profit (referred to as “EBITDA” or earnings before interest tax depreciation & amortization) however while this concept may seem simple, there are several valuation mistakes business owners often make when determining the value of their company.

M&A Business Valuation Mistakes Can Happen - What Do you Do?

Mistake #1 Relying on Future Results to Determine Current Valuation


This is commonly referred to as the “hockey-stick” syndrome. Sellers are naturally optimistic about their business’ outlook and oftentimes price future growth into their value expectations. The challenge is that business buyers pay for “sustainable” cash flow and proven growth. If a business has grown for 3% annually over the last five years but the seller is forecasting 40% growth over the next two years, the seller will need to demonstrate a high level of certainty that this growth is real (signed customer contract for example) or else the buyer is unwilling to price in these future expectations. In most instances, future growth is priced into a deal through an earnout (ie. A future payment tired to performance), this way the seller receives value today for the current EBITDA generated but any expected growth in profit is captured via a future earnout payment.


Mistake #2 Mixing Asset Value with Enterprise Value


For asset-intensive businesses like a manufacturing company, owners must continually spend to replace and upgrade their capital assets, this is referred to as capital expenditures or “CAPEX”. Deferring CAPEX can undermine the competitiveness and profit margins of the business which hurts the overall value of the business therefore deferring such investment prior to a business sale is usually unwise. The tradeoff of valuing a business based on EBITDA however is that the asset value of the capital equipment owned is not included in the valuation approach. Therefore, some sellers look to recoup their capital investments by asking for a multiple of EBITDA plus the book value of their equipment. This presents a challenging question, as a buyer, do you value a business based on its cash flow ability and then also pay for the equipment value which was used to generate this same cash flow? In our experience, most buyers do not pay for the equipment value when following a cash flow valuation approach as they view it as double dipping. This ultimately results in some sellers mistakenly overestimating their business’ value when grouping the value of their cash flow with the value of their equipment.


Mistake #3 Forgetting About Working Capital


A common mistake sellers make is looking at the value of their balance sheet (cash + inventory + accounts receivable) and adding these amounts to the value of the offer they expect to receive based on their cash flow. For example, if a business generating $500,000 in EBITDA is worth a 4x multiple (therefore the enterprise value is $2M) and there is $1,000,000 worth of net working capital on the balance sheet, is the total value of the business $3M? Not quite. In most share sales, the buyer pays for the enterprise value of the company and a certain level of required net working capital is left behind at no expense to support the buyer in transitioning the business’s operations. Required net working capital is a highly negotiated topic in M&A negotiations because it can have a huge impact on the net value remaining to the seller. For example, in the previous scenario, if the buyer and seller agreed that required net working capital is $100,000 to sustain the $500,000 in EBITDA, then the seller is entitled to the remaining net working capital of $900,000 ($1,000,000 minus $100,000 left behind) plus the $2M offer. Now if the company requires a significant amount of inventory or receivables to sustain its operations and required net working capital is $800,000 instead, the net amount remaining to the seller is only $200,000 and therefore the total value of the business is materially less ($200K + $2M). Not factoring in the amount of required net working capital left behind in a sale is a key mistake sellers make when estimating what their company’s total worth.


Mistake #4 Inflexible Value Terms


Business owners oftentimes get fixated on a certain number for their valuation. The challenge is how does that number get paid? All cash? Is there a vendor note paid out over three years for a portion of the deal? Or a performance-based earnout? It all depends on how sustainable the earnings of the business are and what the transition risk is for the seller. While a business that generates $1,000,000 in EBITDA may be worth 4x, if majority of that profit is generated by a single customer, buyers may be willing to pay 4x but over time through an earnout to mitigate the customer concentration risk. The golden rule is that terms dictate price. The more willing a seller is in sharing the risk and financing the buyer via an earnout, vendor note or rolled equity, the more willing a buyer is to meet their desired valuation. If sellers are inflexible on terms and have a desire to receive their number upfront, unless the business is highly desirable and exhibits a lot of attractive characteristics, business buyers wont be willing to pay for that value upfront. Flexibility is sometimes key to closing the best deal for the seller.


Mistake #5 Excluding Invisible Operating Costs


While most private businesses sell based on a multiple of cashflow, not all companies do. For capital intensive businesses where capital expenditures is required annually to sustain a company’s profit level, business buyers are smart enough to account for the invisible operating cost – CAPEX. In such a situation calculating your company’s EBITDA and not accounting for CAPEX may overvalue what buyers are actually willing to pay for the business’ net cash flow. For example, an equipment rental business that generates $3M in EBITDA annually but spends $500K on average per year on equipment purchases to replace older assets in their fleet will be more likely to be valued on free cash flow basis (EBITDA less CAPEX = $2.5M) rather than on the EBITDA value of $3M. When evaluating your company’s worth, its important to also consider invisible costs like CAPEX, how much do you need to spend annually to sustain your current business? Netting that amount from your EBITDA will provide a more accurate view of your business’ true cash flow. In the most extreme instance, if your business is heavily asset-dependent (for example: an airline) it may not make sense to value your company based on a multiple of cash flow but rather a mix of book value and goodwill value in order to fairly capture the depreciated value of the assets owned by the business.


About the Author – Robert Bezede is a Canadian-based M&A advisor working with lower mid-market companies valued between $1 to $50 Million in enterprise value working across a broad range of sectors. If you or someone you know is looking to sell their business, please reach out to Robert via LinkedIn or send an email to robert.bezede@robleecapital.ca


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