Ask several business owners what their company is worth and you may receive very different answers. Some will base it on annual revenue. Others will apply a multiple they heard from someone in the industry. Some will compare it with another business that recently sold. Others will start with the amount they need for retirement.
Each approach may provide a point of reference. None, by itself, is necessarily a valuation.
Mistake 1: Valuing the business based on what you need
The amount an owner wants or needs from a business sale does not determine what the market will pay. An owner may need a particular amount to retire comfortably, repay debt or fund another investment. That financial requirement is important for personal planning, but it does not automatically determine the value of the business. If the value of the business and the owner’s financial goals are not aligned, identifying the gap years before a sale provides far more options than discovering it once the business is already on the market.
Mistake 2: Applying a multiple without understanding it
Valuation multiples can be useful, but only when the earnings figure and the multiple are appropriate for the business being assessed. A multiple used for one industry may not apply to another. Even businesses in the same sector can carry very different levels of risk. Size, growth, customer concentration, recurring revenue, owner dependency, staff structure and market demand can all influence the multiple a buyer may consider reasonable. Simply hearing that businesses in a particular industry sell for a certain multiple is not enough. The important question is what earnings measure is being used and why that multiple should apply to this particular business.
Mistake 3: Using revenue alone
Revenue is easy to see, which makes it tempting to use as a shortcut. But revenue does not show what it costs to produce that income. A business generating significant revenue and very little profit may be less valuable than a smaller, highly efficient business producing stronger earnings. Revenue quality also matters. Is it recurring? Is it concentrated? Is it growing? Is it contractually secured? The headline sales number rarely tells the full story.
Mistake 4: Treating every expense as an add-back
Private businesses often contain expenses that would not necessarily continue under new ownership. Identifying legitimate adjustments can be an important part of determining maintainable earnings, but problems arise when virtually every expense is treated as optional. Buyers will examine whether costs genuinely disappear after the transaction. If a replacement owner needs to hire someone to perform work currently undertaken by the seller, for example, that cost cannot simply be ignored. Adjustments need to be reasonable, supportable and clearly explained.
Mistake 5: Ignoring risk because the business has always performed well
Historical performance is valuable evidence, but it is not a guarantee of future performance. If one customer represents a large proportion of revenue, a key employee holds critical knowledge or the owner personally manages every important relationship, a buyer will normally consider what could happen after the ownership transition.
A valuation needs to reflect both performance and the risks attached to maintaining it.
A useful valuation needs context
Business valuation is rarely about applying one simple formula. It involves understanding the financial performance of the business alongside its structure, risks, customers, staff, systems, industry and market. That is why informal estimates can sometimes differ significantly from a detailed valuation. An estimate may provide a useful starting point. A proper valuation should explain not only what the business may be worth, but also why. For an owner trying to make decisions about the future, the “why” can often be just as valuable as the number.
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Regards,
Tony Arena