Business valuations in small companies prior to a sale

Worlds apart – or more similar than we think?

Previous posts have shown that there are tons of different strategies and models you can choose from when it comes to valuating your company. Some tend to look backwards, some tend to look forward, some will dial down your numbers, and others will make them look good. Maybe sometimes even too good. There is a danger with dressing up your numbers too much, especially if you are in negotiations to sell your company.

Comparing yourself to others and getting caught up

Most of the discussions regarding showing off good numbers revolve around the use of relative benchmark valuation. The use of the benchmark valuation model can vary a lot from year to year. The model is based on finding an average in an industry by comparing companies to each other, and then using that average to determine a relative value. If a certain industry has experienced a year with unusual circumstances, the relative valuation will be off. If you then move on to applying a price/earnings ratio or an EBIT-multiple without any adjustments, it is inevitable that a higher ratio number will ultimately give your firm a higher value. It is easy to get caught up in wanting to push positive trends in a time of divestment. The buyer naturally wants to see a fundamentally sound company. These factors will push the sales value up, benefitting the seller. But does dressing up your numbers come at a price?

The cost of pretty numbers

First and foremost, there might be legal consequences following the dressing up of your numbers. If your previous annual numbers were inflated by aggressive revenues or expenses, it could skew the accuracy of the valuation. Besides legal action, it could lead to industry discussions and an overall distrust.

Secondly, we are all familiar with accounting 101 – the numbers eventually have to match up. The revenues and expenses should be equal to the cash flow in the long run. Any differences would be because of accruals and the adjustments made to balance out the revenues that have been earned, or any expenses that have been incurred but not yet recorded. These effects happen at different times, and will balance out the numbers in the long run. On that account, hyped up earnings today will inevitably lead to downplayed earnings tomorrow. Furthermore, many acquisitions include clauses in their contracts. One of these clauses could link additional payments with future performance. If the numbers are too dressed up, and thus promising more than can be delivered, it can end up being a costly deal for the seller.

Moving on, the third reason for not trying to manage your numbers too much is that in a short-term view, it may not even make that much of a difference. If the buyer conducts his research on a more in-depth level and takes the history of the business into account, then short-term number improvements only play a modest role in the valuation. If serious, both buyers and sellers will want to have the most accurate valuation available.

Pretty from the inside out

That being said, a valuation should be higher than your tangible assets. The appeal to a buyer is also the intangible assets: the knowledgeable employees, customer lists and business processes. Assets that are needed to maintain daily operations, but that are difficult to monetize. Without doing a proper valuation through an appraiser, you risk either setting your price too high and scaring off potential buyers, or setting it too low and essentially leaving money on the table. Both situations are less than desirable, right? An outside expert also adds credibility to your numbers, since the buyer will be able to see how you’ve arrived at your asking price. Our valuations are based on research, your own expectations about the future, as well as medium and long-term assumptions. It is vital that you focus on real business developments in your forecasts in order to make the valuation as accurate and true as possible. Good looks and dressing up is all fun and games but when the makeup and fancy clothes come off, it is what is left on the inside that counts!