3 Common Business Valuation Mistakes

Selling a Small Business - Some Common and Scary Business Valuation Mistakes

There is a great deal of confusion when valuing a business and business sellers tend to make the same mistakes. The startling fact is that unfortunately, so-called professionals often repeatedly make these same mistakes.

Mistake # 1 – Applying a ‘one size fits all’ rule of thumb when valuing a business

For example, multiples of profit, multiples of rent rolls or percentages of revenue etc.


While a one-size fits all appraisal method is simple, unfortunately it does not result in accurate business valuations.

A study of the actual sale prices of 5000 small businesses showed the sale price/cash earnings multiple ranged from 0.1 times the earnings with a median of 1.75 times the earnings.

Therefore, it is apparent that applying the average or median ratio as a one size fits all multiplier produces misleading and unfair results, particularly to the better businesses.

Mistake # 2 – Using Contrived Methods when valuing a business

For example, Super Profit - This is one of the more unusual (silly?) appraisal methods, where the method assumes that different parts of the investment in a business have difference levels of risk. Hence, should return differnent rates of returns on the investment.

For example - The plant and equipment in a small business is far less risky than the cash flow.

In reality, when a small business goes under, all business assets lose substantial value - nothing is
protected.

The engine room and fittings of the Titanic were subject to the exact same voyage risk as the
rest of the ship!

Contrived methods were first used in the US in the early 1920's when American lawyers had trouble understanding discounted cash flow. The concept of 'super profit', while having an illogical grounding, was easily understood by lawyers and judges, and was used until fairly recently to settle equity cases - SCARY!

Mistake #3 - Neglecting To Include WIP (Work In Progress) In Business Valuations

It is quite amazing how even people who should know better often overlook WIP when valuing
a business.

WIP is a key element of the business value in both professional practices and contracting
companies. In these environments, there is usually valuable work in progress still to be
invoiced.

We recall an instance in Australia where a major public company sold its contracting and
engineering business and its appraisal overlooked a substantial amount of WIP in the business.
In effect, the lucky (canny?) buyer recouped the purchase price in less than 3 months.
Essentially, the WIP the buyer got free was invoiced and paid - WHOOPS!