Business Valuation Mythology 101 – Part II

In our “Business Valuation Mythology 101 – Part I” blog article, we outlined some common misconceptions often held by sellers on how potential buyers view and value their businesses.  Myths one to four included 1) asset quality, 2) industry-standard multiples, 3) enterprise value equals equity value, and 4) the working capital assumed in the transaction.  In Part II we outline three additional common myths often held by sellers, including owner benefit add-backs, growth projections, and potential synergies.

Myth #5 – Owner-benefit add-backs
It is not uncommon for closely-held businesses to accrue some benefits to their owner(s) as business expenses, to minimize taxes.  After all, no one likes to pay more taxes than necessary.  Legitimate owner-related expenses such as a company car, travel, meals, etc., should not be added back to earnings when the financials are presented to a potential buyer unless they are “above market” or it can be demonstrated that they will disappear under new ownership.

While personal items such as the family cottage renovation expenses or the country club membership should be added back, it forces buyers to distinguish between a legitimate future business operating expense and those that will be non-recurring.  This can create uncertainty and can impact a buyer’s perception of value as well as their appetite for completing a deal.  It rarely is as simple as identifying and adding back the personal historical expenses.

It is always best to have clean financials, (or even audited statements), purged of any unjustifiable personal expenses, for at least a few years before the sale of the business.  This may mean the business will pay more in taxes but it will help bridge any gap between taxable income from the company’s tax filings and the financial statements.  Most professional buyers will value the business based on GAAP (Generally Accepted Accounting Principles) or some other accounting standard such as IRFS (International Financial Reporting Standards) rather than OAAP (Owner Accepted Accounting Principles).

Myth #6 – Growth projections - The buyer will pay for the business's growth potential 
While this is partially true, the proverbial “hockey stick” projections presented by an overly optimistic seller is usually highly discounted by a buyer, especially if it is based on a strategy that the seller has little experience in executing.  Buyers will make some assumptions on growth as they build their valuation models, however, those assumptions will be mostly based on historical trends.  Anything above this trend will be treated more as “ideas” rather than viable projections.

While ideas create optimism on what may be possible for a new owner, any tie-in to the financial projections should be layered-in and presented more as speculative potential, rather than true projections.  It is important to separate what is doable based on track record and what is possible based on new ideas, wherever possible.

Myth #7 – The buyer will pay the seller for potential post-acquisition synergies
Synergies can be cost savings, such as when redundant personnel are eliminated post-acquisition, or revenue synergies, such as cross-selling opportunities.  While the magnitude of synergies varies by each potential buyer, their value may not be reflected in an offer to the seller, since there is a risk that the synergies will not materialize.  Of course, there are always exceptions.  For example, where a big industry player makes a highly strategic acquisition and pays an outsized multiple for a scarce asset.  But in normal M&A transactions, the buyer will tend to pay the least amount they can or at least no more than fair market value (FMV).  They will often only make offers that exceed FMV when they are pushed via a competitive marketing process.  Even then, many strategic buyers exercise discipline and will not pay more than their perception of FMV, particularly if have a robust pipeline of potential acquisition targets and can simply “move on” to the next target.

There can be situations when there is a strong case for a buyer to use some of the future expected synergies to sweeten an offer beyond FMV to knock out other competitors from acquiring a target.  However, in most cases, both cost and revenue synergies are used primarily to justify the acquisition with internal stakeholders, such as lenders, outside shareholders, or investors.

There are several other myths out there that we will address in future blog articles.

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