When it comes to valuation, there are, unfortunately, many misconceptions in the industry. More often than not, owners have an unrealistic valuation expectation for their business, and do not have a clear understanding of how value is actually derived. The reality is that our industry is ever-changing and constantly facing a host of challenges that impact businesses and how they’re viewed and valued. Today we’ll examine some of the common myths, as well as explain the reality of each.
Myth #1: There are industry-accepted standard multiples.
Reality: There are no standard multiples, just “rules of thumb”.
While there are “rules of thumb” when calculating a baseline valuation for a firm, the multiples you’re accustomed to are a moot point when it comes to getting a deal done. In fact, no two businesses are alike and no two firms are alike – by extension, no one “standard” multiple can exist as a fair assessment of value.
Buyers often back into a “multiple” to make the seller more comfortable with the deal. In reality, a sophisticated buyer will use a calculation based on their expected Return on Investment (ROI). Since the seller isn’t concerned with the buyer’s return, the buyer will translate the value into a number the seller can more easily identify with. For example, most buyers want a 15-18% return on their investment. Once the purchase price is calculated, they’ll translate that number into a multiple of ‘x’ (perhaps revenue, EBITDA, or EBOC).
Myth #2: My firm’s value is based upon its financial attributes.
Reality: A firm’s value is based upon not only the financial attributes, but also its non-financial and even intangible attributes as well. While historical financials are certainly important, they’re not the only component when determining value. Factors affecting valuation include:
· Strength and depth of management team
· Capability/intention of next generation
· Growth (historical and projected) of cash flow and AUM
· Reputation and brand equity
· Firm size (AUM, geographic footprint, staff)
· Client base compensation (age, tenure, relationship)
· Transferability of revenue stream
· Continuity plans for the Firm
· Capacity vs. scale
· Corporate tax status/structure
· Organizational and operational issues
· Client service model
Also keep in mind that buyers will have certain objectives they’re hoping to accomplish. Everything from product line to talent to technology will establish whether a premium or discount will be applied.
Myth #3: Maximum value is the number in the valuation.
Reality: In transactions or sales, you cannot separate value from structure.
Purchase price is only part of the deal; structure is equally as important and can raise or lower what the seller ultimately nets. Deal structure typically consists of some combination of a down payment, promissory note (adjustable or fixed), and earnout. Additionally, a “clawback” provision can be added to protect the buyer in the event of client attrition. All of these can potentially impact the final “value” that a seller ultimately receives. And don’t forget the taxation aspect of a deal - whether deal components are treated as capital gains or ordinary income have an impact on both the buyer and seller.
Myth #4: Valuation is based upon a specific point in time.
Reality: Valuation takes the past, present, and future into consideration.
A buyer is not purchasing your firm based on what it has done historically or at any given point in the past, but rather what it can do going forward. Again, a Firm’s history is important, as it tells a story – but it is only a small piece of determining value. Buyers buy the viability, stability, and predictability of future profit.
Myth #5: Using a multiple of revenue approach is the most commonly accepted valuation method.
Reality: The multiple of revenue approach is the least accurate and least accepted method.
We all know that every dollar of revenue has an expense tied to it. Net income (or cash flow) is what really matters. For this simple reason, the multiple of revenue approach is the least accurate method and what buyers care the least about. Remember that buyers want a firm for what it can do going forward. That’s why the discounted cash flow methodology is usually the most widely used and accepted. The DCF model projects future cash flow and discounts it back to present day value (based on the firm’s KPIs).
Myth #6: The valuation that I had done is what my firm is worth.
Reality: A valuation, whether formal or informal, is only a baseline and not a true indicator of a sale price.
The ultimate value of a firm is what a willing buyer and a willing seller are willing to agree upon. Periodic valuations provide a check and balance for any offer a seller might receive, but a valuation is merely a starting point. (Hint: If you’re a seller, never present a prospective buyer with a valuation you’ve had performed on your business – allow the buyer to complete their own.) And don’t forget that deal structure is just as important as purchase price.
Myth #7: I will be able to sell or transition my firm for a value that will allow me to fund my retirement.
Reality: The market does not care about your retirement.
Owners often hold a concentrated stock position in their businesses, failing to diversify their personal wealth – and expect to receive maximum value at a moment’s notice, at a time that is most convenient for them. Unfortunately, life just doesn’t work this way. Your value is your value, regardless of when or what you need to comfortably retire.
Myth #8: Having good revenue and low expenses equals strong cash flow and greater value.
Reality: Low expenses can sometimes mean I have not reinvested in my business.
While it’s true that strong cash flow is an attribute, falsely inflated cash flow can be a detriment. A well-run business is one that wisely invests in itself on a regular basis – after all, investments are a calculated business risk. Failing to make the proper investments in your business (for example, in technology), will typically lead to a lower valuation, as a buyer will need to discount the value to “fix” what is lacking. Be careful about being penny wise and dollar foolish.
Myth #9: If something happens to me, the firm will be sold at fair value.
Reality: Upon an unforeseen event, many firms will experience immediate value erosion.
Statistics show that revenues drop 60% when an owner dies. As a relationship business, if the owner is the primary client contact, it’s easy to understand how value drops significantly should the unexpected occur. Even in instances where there is an interim/emergency or long-term succession plan in place, client attrition is nearly inevitable. That means more risk to the buyer…. and thus, a lower value.
Myth #10: My compensation is considered an add back to profit.
Reality: Not necessarily, especially if you are taking the majority of your compensation based upon the performance of the firm or haven’t built in management replacement costs.
EBOC can be a tricky calculation to understand. Think of it this way – if you sell your business and someone is needed to replace what you do (i.e., an advisor being paid a salary to manage/service your clients), that salary is subtracted from the cash flow of the business. Similarly, any K1-type distributions are not added back. What you can do, is normalize your compensation (for instance, say you take $400,000 as comp, but could be replaced at $125,000 – you’ll add back the difference) and add back any “perks” that you run through as an expense item (i.e., automobiles, cell phones, etc.).
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