When we start working with business owners, their first question often centers around how much their business might be worth. And it makes sense - business valuation is a complicated topic and most owners aren’t familiar with the process.
Unfortunately, some business valuation “experts” don’t have as much expertise as they would like you to believe. We’ve seen some pretty bad errors in valuations our clients have received before working with us.
We’ve also sold hundreds of businesses and know which valuation techniques hold up in the real world.
In this article, we’ll cover the most common errors we see so you can avoid them. Since you specialize in running your business and not valuing it on a day-to-day basis, we want to make it easy for you to spot these potential errors.
Let’s jump in.
1. Not Using The Correct Earning Stream
One of the most common ways brokers can incorrectly value businesses is to use the wrong earnings. There are a bunch of different ways to measure how much money your business makes (think net income, cash flow, EBITDA, or SDE) and some are better than others for valuing your company.
Small business valuation specialists will generally use Seller’s Discretionary Earnings (SDE) or EBITDA to value businesses.
SDE, or Seller’s Discretionary Earnings, is a measure of how much profit your business provides to a full-time owner-operator. We put together a guide on how to find your SDE here.
EBITDA is another measure of profit that takes your net income and adds back in your interest, taxes, depreciation, and amortization. We have a guide to EBITDA here.
There is no one-size-fits-all policy for which to use, but there are good rules of thumb:
- EBITDA can overvalue a business that is too small to use EBITDA
- SDE can undervalue a company that is too large to use SDE
- Net income generally undervalues businesses and is not a good method
Businesses with less than $1 million in earnings should be valued using Seller’s Discretionary Earnings and businesses with more than $1.5 million in earnings should be valued using EBITDA.
However, businesses with $1 million to $1.5 million in earnings can use either SDE or EBITDA. It is up to the valuation specialist to determine which multiple is more appropriate for the specific company.
2. Not Using The Right Multiple Because You Used The Wrong Comps
To determine the value of your business, an analyst will take your earnings and apply a multiple to it. They find the multiple by looking at comparable sales (comps) of similar businesses in your industry, location, and size.
If the valuation analyst does not perform sanity checks of these comps and takes them at face value, they can include outliers (abnormally high or abnormally large comps) that skew the multiple. Comps can differ heavily because:
- A business was sold to family members or employees (for a lower price)
- Some include real estate and others do not
- Some businesses sell for abnormally high or low multiples (distress sale for example)
Valuation specialists who know how to sort through comps properly and what to do when they encounter outliers can give you a more accurate idea of what your business is worth.
3. Trying to Use The Wrong Approach For The Size of Company
As we mentioned above, lower middle-market companies are generally valued using a multiple of SDE or EBITDA. Some valuation analysts, usually those with banking backgrounds, will try to use a discounted cash flow model (or DCF for short) to value small businesses.
This approach will produce an overvalued company because the normal discount rate range does not apply to small businesses. Small businesses in the $1 to $25 million revenue range will have much higher discount rates than public companies. Using the discounted cash flow model (DCF) for a company under $1 million in earnings is not common.
It is uncommon for small business valuation analysts to use DCF because SDE and EBITDA produce more accurate results for businesses of that size and have more comparables available. Using asset-based valuation techniques for small companies also does not work and will undervalue companies.
4. Trying to Value Based Off Future Performance Instead of Historical Performance
We see a lot of business owners who want to value their business based on future earnings instead of historical earnings because they know their business has a lot of potential.
While there is some truth to the idea that the buyer is purchasing the future cash flow, in most cases, the valuation will be based on historical figures. Your business's future performance is accounted for in the multiple.
If your business has grown quickly historically, your multiple will be higher to account for that. However, your buyer will want to see some stability. So they will want to value on an average of the last couple of years, not just the past year.
5. Misunderstanding What is and is Not Included in Comparable Sales Databases
Say you’re valuing a business, so you go into your database of recent business sales and start looking through the comparables. You see another business in the same industry and of the same size sold for 3x Seller’s Discretionary Earnings last year.
Now, what if that sale included $750,000 in equipment and the business you’re valuing only has $100,000 in equipment. That would be pretty important to know, right?
Some brokers and valuation analysts do not know what information is included in the comp database they are using and might be making this exact mistake. It’s critical to understand what is included in the comparables you are using. Some examples are:
- Was equipment included in the sale? If so, what was the value?
- Was inventory included in the price? If so, what was the value?
- Did the price include real estate? Or did the buyer lease the real estate?
- How long of a training period did the buyer receive? And the non-compete?
Some comparable sales databases do not have this information available. Other sources provide this information but it is only as accurate as the brokers who submit it to the database.
6. Not Normalizing The Rent or Other Expenses
The expenses you currently have may not be the same for the new owner. If the professional performing your valuation does not account for this, it can impact your valuation’s accuracy.
For instance, say your business does $500,000 in Seller’s Discretionary Earnings but you own the building and do not pay yourself rent. The SDE might actually be $400,000 because the new owner will have $100,000 in rent expenses that you did not have.
7. Double Counting Section 179 Deductions as Depreciation
Section 179 is a government tax program designed to incentivize small businesses to purchase equipment by allowing them to write off big equipment purchases in one year.
There are different ways to account for a section 179 deduction on your taxes. It is critical that your valuation analyst or broker understands where your CPA put your section 179 deductions to accurately figure your SDE or EBITDA.
The most common error is adding back a section 179 deduction that was never expensed on your income statement. If a broker does this it will cause your valuation to be much higher than it should be and hurt the relationship you have with your buyer.
Buyers are very keen on detecting this because capital expenditures (buying vehicles and equipment) are typically a large part of their analysis.
8. Using Cash Basis Statements Instead of Accrual Basis Statements and P&Ls Instead of Tax Returns
As a business owner, even if you keep your books on a cash basis, you should send accrual basis statements to your valuation provider. Accrual basis statements lead to more accurate business valuations.
The same goes for P&Ls and tax returns. You may use P&Ls internally to view your company’s financial status, but your valuation provider will need to use your tax returns to value your business correctly.
Want to see an example of an accurate business valuation?
Download our Sample Small Business Valuation Report Here:
Spot Incorrect Valuations Before You List Your Business
An incorrect business valuation can do one of two things - waste your time or rob you of the price you deserve. Spotting a bad business valuation early on gives you the power to get a better valuation and list your business at a more accurate price.
Learn more about what business valuations are and how much they cost by reading “What is a Business Valuation? (And Which Type Is Right for You)” and “How Much Does a Business Valuation Cost?”