Jul 16th, 2013 by Achim Neumann, President
Very often, a business owner’s price expectation for the sale of a business is substantially “off the mark” – interestingly enough though, these misestimates occur in both directions – under and over! In less than 10% of all scenarios are the expectations consistent with what the Fair Market Valuation subsequently determines, or with what an investor is truly willing to pay. Why is this?
“One of the key reasons for a consistent ‘overvaluation’ is the seller’s expectation for the buyer to pay for future improvements in business performance – either due to changes in the general economic or specific market niche conditions or due to a future owner’s changes in the business structure”, says Achim Neumann, President, A Neumann & Associates, LLC, a New Jersey – based merger & acquisition and business brokerage firm.
Generally speaking, however, investors are not willing to pay for expected future improvements, most certainly not the last one, simply because the investor argues that if he / she needs to implement the changes, then credit should not go to the previous owner. Alternatively viewed, if the potential for an improved business structure is indeed available, then the (current) business owner should make the changes first and then sell the business.
“There are exceptions, though,” says Michael Gersten, Managing Director, Northern New Jersey & Southern NY State. “If there is a justified expectation of a market improvement, then both parties can agree on a deal structure that takes such improvements into account. We have successfully put many such deal structures into place, however, such business improvement needs to be due to external events, and not due to the (new) owner’s willingness to make substantial changes to the business.”
The challenge for many business owners then is accepting a more realistic asking price. Indeed, after performing a Fair Market Valuation by an accredited third party valuation firm, an “outsider’s view” will most certainly move expectations to a more realistic value, specifically, with respect to two factors: goodwill and deal structure.
Goodwill, often perceived as a nebulous concept, is actually a factor that can be fairly easy determined, by comparing the existing cash flow and the market based company value with it’s asset base. “We have provided over 500 valuations over the past ten years, and every one had a fair market determination of the goodwill, ’” says Gary Herviou, Managing Director Central NJ & Lehigh Valley.
More challenging is the deal structure, which often contributes to unrealistic price expectations. As mentioned before, if there are expectations for a substantial improvement in the business climate, then the deal structure has to take this into account.
Beyond that, however, several other factors come into play. For example, the lack of a seller note will typically drive down the FMV of the transaction by 10% to 30%, even though, in many transactions the seller note will ultimately never be used.
A second factor, such as the current low interest rates available from the SBA, will allow for a higher ROI for the investor and therefore for a higher transaction price. As recently reported, “Small-business lending activity is on the rise, but the size of loans is shrinking, new data shows. The total number of small-business loans jumped up 10.4% last year, according to a report released Wednesday by the U.S. Small Business Administration’s Office of Advocacy.” [The Wall Street Journal, July 15, 2013]
Such increase in lending is very often an outcome of low interest rates, which in return provides for a more favorable deal structure and subsequently more deal flow.
“All in all, there are many factors that contribute to the determination of a Fair Market Value of a business,” says Neumann, “and it is truly unrealistic to expect a business owner to sort out all these factors. Using an accredited third party professional’s opinion and relying on M&A professionals active in the field on a daily basis, is certainly the more prudent way to go.”
A Neumann & Associates, LLC is a professional merger & acquisition and business brokerage firm with 30 years of experience in New Jersey, New York, Pennsylvania, Delaware and Maryland that assists business owners and buyers with the business transfer process in a completely confidential manner. The company is affiliated with BBN, with 450 offices and access to a national network of qualified buyers and sellers. For more information, please contact A Neumann & Associates at 732-872-6777.