It’s often said that a business is worth whatever someone is willing to pay for it, so why should a business owner bother with a formal valuation, especially if they have no immediate plans to sell?
After 50 years of valuing closely held businesses and assisting owners in preparing for ownership transitions, we’ve found that one of the biggest misconceptions is the belief that knowing the value of your company before you’re ready to sell is unnecessary. After all, isn’t the true value just what a buyer is willing to pay?
The short answer is no, because you need to have a starting point for negotiation and you may well be leaving money on the table. All too often, we hear, "I wish I had looked into this sooner."
Here’s the longer answer. When a company is valued, the appraiser examines past performance and models the future business plan and cash flows under the current ownership. This is the quantitative aspect of the appraisal. Additionally, there are qualitative factors that influence how those future cash flows are discounted to determine the present value of the business. Once identified, both quantitative and qualitative factors can become areas for improvement, potentially increasing the overall value of the company. The good news is that once a business owner understands these drivers of value, the value can indeed be increased. The challenge is that it takes time, and the drivers, or focus areas, are unique to each business.
Many business owners spend their entire careers growing sales and profitability—two key drivers of value. However, increasing sales alone doesn’t necessarily boost value. Profitability is certainly crucial, but the missing piece of the puzzle -- and potential missed opportunity -- is understanding the qualitative factors and how well the company performs in each of these areas. We discuss these qualitative factors in more detail in a previous blog post here.
When it comes to translating business value to price, the amount a buyer is ultimately willing to pay is the result of negotiations between the seller and buyer, influenced by several factors:
- Starting Point of Negotiations: If the seller understands their business’s value, considering all quantitative and qualitative factors, they come to the negotiating table with a well-supported number. This confident presentation impacts the final price more than any other single factor.
- Motivations of Buyer and Seller: The motivation levels of both parties significantly affect negotiations. For instance, if the seller is ill, aged, or burned out, the buyer may perceive an advantage and offer a lower price. If the seller does not seem in a hurry, has had a business valuation done and is confident, the buyer may perceive that the asking price is reasonable.
- Payment Terms: Is it an all-cash deal, or does the seller need to finance part of the buyout? If the seller can secure most or all of the purchase price upfront, they may accept a lower overall price.
- Performance-Based Price Adjustments: A buyer might be willing to pay a higher price if future payments are tied to the seller achieving specific growth, profitability, or improvement targets.
Most business owners are well-versed in the operations and finances of their companies but are less familiar with business valuation and how that translates to the price a buyer would be willing to pay. This is understandable, as not all have undergone the valuation process. However, understanding both the quantitative drivers and qualitative factors of value is crucial to help manage a business as the investment that it is. With this knowledge and time, the value of a business can be significantly increased, enabling the owner to negotiate a higher sale price.
Knowing your company’s value is the essential first step in planning for its future, regardless of when you plan to sell.
Do you have questions about the key value drivers of your business? Contact us for a complimentary discussion. Every business is unique, and we’ve seen a lot of businesses in our 50 years!
