The Valuation in your Head is Probably Wrong

I met with a client recently who had, in the absence of a formal valuation, determined his pricing expectation of his jointly owned business. The business was not at scale yet, meaning it was geared up but not yet generating substantial profits. The purpose of the valuation was that the fifty percent, passive shareholder was exiting, to make room for two new shareholders – those driving the business.  

We see varied valuation estimates and beliefs from varying parties, multiple owner businesses, divorcing spouses, you can imagine. In this instance, the exiting party has a valuation expectation that is double the estimate we have. We have not undertaken a formal valuation yet, however reviewing the data suggested a large difference.  

So how are these so different?

Rule of Thumb – Industry rules of thumb are dangerous beasts. These days a rule of thumb is simply a methodology used in a contract. The price is determined based on profitability, and linked back to client revenue so appropriate claw backs can occur for client loss.  

Future Maintainable Earnings – We can argue for hours about what should and should not be adjusted for in your valuation, however as a starting point, you need to consider the current and ongoing costs of the business. Determining your wages cost as a percentage, and reducing it in your valuation is only appropriate where: 

  • The wage is paid to a related party and is ‘above market’, and this will be adjusted when other equity holders buy into the business.  
  • The reduction in cost is occurring because of redundancies, resignations or the like. That is, the cost will be reduced in the future.

As a business owner, it is important to have a reasonable market estimate of your business value in your head, particularly where there are multiple parties or you are likely to transact on equity. This is relevant for expectations of a higher or lower valuation.

Higher Valuation Expectations

Where you have higher valuation expectations, you may need longer to execute any plans, because you may need to:

  • Implement business improvement strategies 
  • Wait until the business reaches a level of scale (e.g. continue building the business) 
  • Make cost savings to the business and show that these are realistic  
  • Introduce equity holders over a longer period of time, in tranches.

Lower Valuation Expectations

We have seen businesses transact equity on low valuations, where they have used the wrong multiple. This can make any future sales of equity difficult, as the ‘price increase’ can be unexpected. Unless you genuinely want to discount the price (e.g. via sweat equity discounts), pricing your business fairly is always the best way forward.

Understand your Value

There is no replacement for understanding your business valuation, and any changes to this through the year. Any good business valuer will communicate your business value and methodology to you in a way that can be replicated. Once you have this, you can ‘estimate’ your valuation for the next year or two with a reasonable basis. Better yet, having appropriate shareholder agreement valuation clauses can reduce any disputes.  

Speak to us about understanding your business valuation now and the right methodology for you going forward, to avoid any uncertainties.

About the Author
Fiona Ettles , Hobart
Fiona is enthusiastic about informing and reassuring clients of their financial position, be it in regard to the value of their businesses, or their tax returns. She enjoys working with clients to understand their problems, consider solutions and implement plans to better their lives, whether this be in the short or long term.
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