Business Valuation Mythology 101 - Part I

Myths about private company business value abound in the private capital markets.  Part of the reason for this is that there is often very little data to make accurate comparisons, or when the information is available, it is either out-of-date and/or there is little contextual information available.  Another reason is that business value is not something most business owners think about regularly as they are often not talking to buyers, private equity groups, and other types of investors daily.

While precedent transactional data and non-publicly available deal insight by M&A advisors can be helpful, it is only part of the solution.  Most buyers will spend considerable efforts to build out the financial models to carefully assess what a potential business is worth to them, and act/bid accordingly.

This blog article addresses some of the common myths business owners often have about how a buyer will value their business when they put it up for sale.

Myth #1 - The more valuable the business’s assets, the more valuable the business
While quality assets are a component of a business’s value, it is their ability to generate cash flow that drives value.  Cash flow can be used to reinvest and grow the business, pay down debt, or be paid out to shareholders.

Typically, asset-light businesses trade at higher multiples than asset-heavy businesses, for the simple reason that cash flow is not tied up in replacing assets as they wear out.

Owned real estate can be an exception.  It can also be a tricky component of the valuation assessment, as sometimes the value of the real estate has appreciated over time, but there have been no corresponding rent or lease expense increases that are based on the market.  A highest and best use assessment of the property may indicate that most of the value of the business is in the real estate itself, rather than the operating business.

Myth #2 – Industry-standard EBITDA multiples or “rules of thumb” metrics can establish business value
Average multiples or “rules of thumb” metrics can, at best, crudely estimate value, and really should only be used as a “check” once a proper valuation assessment is made.  By definition, an average means that most businesses are worth more or less than the average.

There are dozens of interacting factors that are unique for each business that impacts the future cash flow it can reliably generate, and therefore its value.  Two companies with the same sales and the same EBITDA may be worth entirely different amounts based on differences in customer/revenue quality, supplier relations, location, etc.

Myth #3 – Enterprise value equals equity value
Private company M&A transactions are normally on a cash-free, debt basis, regardless whether it is structured as an asset or share deal.  In other words, the buyer will pay the seller what they think the business is worth to them (the enterprise value), but the seller will have to use the proceeds to pay off any debt, including lines of credit, term debt, loans from shareholders or related parties, tax liabilities, etc.  On the flip side, if the business has no debt and there are cash or cash equivalents on the balance sheet, the seller normally will keep the cash, or it will be added to the purchase price adjustment at the close.

The enterprise value equals equity value myth is most common when the buyer’s offer is to acquire the shares of the business.  Of course, there are situations where a buyer purchases the existing shares of another shareholder and thereby assumes its pro-rata share of any liabilities, including debt.  This is more common in minority deals, or when the debt terms are more favourable than what a buyer could obtain on their own.  But remember, the pro-rata share value does not equal the pro-rata enterprise value.

Myth #4 – Working capital assets such as inventory and receivables are added to the business value
The logic here is how can a buyer know the inventory and receivables value if they are changing daily.  Therefore, they must be added to the purchase price at close. The truth is that current assets used to operate the business are part of the business value, however, they are offset by current liabilities such as trade payables, prepaid operating expenses, etc.  In other words, it takes a certain amount of working capital to operate the business, and the enterprise value includes an appropriate and negotiated amount of working capital, regardless if it is financed by a line of credit or cash on hand.

The exception may be for very small “main street” type businesses where the owner sells the business plus the inventory on hand at close at cost.
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There are lots of other myths out there that we will address in future blog articles.

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