Thursday, August 7, 2008

Business Valuation Proves Disastrous!

Business Valuations by Amateurs Can Prove to be Dangerous - Recently, I was retained to prepare a valuation on a business with annual sales in the $5 million range. The owner wanted to know retrospectively what the business was worth at the end of three different years, 2005, 2006 and 2007. Why?

The reason for the request was complicated but basically it involved the buying out of two partners... one in 2005 and the other one who chose to leave the business in 2007. Although the business was doing about $5 million in 2005, it was not very profitable. In 2005 one of the partners who owned 10% and who had helped the business grow to that level decided he wanted to sell his portion and pursue other interests.

Fine, so far. Well the owner asked a business broker (possibly related to his franchise) to help value the business. With virtually no reliable logic or reason given, the broker valued the business at $4.5 million. Thus the partner's share was worth $450,000 and a note was negotiated with a payout over 15 years.

The real suffering caused by this erroneous valuation would occur about three years later when a second partner who owned 30% of the business also decides to leave - once again the departure was amicable. Assuming he used the same valuation approach as was casually used in 2005, that would mean he would have to pay the 30% partner approximately $1,350,000 and it didn't take much of a genius to realize that when a business like his is in the 5-8% profit range that there is no way in the world that the business can afford to buy this partner out - certainly not based upon a value of $4.5 million. Something was seriously wrong!

Happy ending? Nope. My valuation of the business as of the end of 2005 was approximately $900,000 and $1.3 million at the end of 2007. Yes, the 2007 valuation was much better and higher than for 2005, but both are dramatically (about 80% lower) than the valuations he received in 2005. Profitability can be dramatically improved in this business and thus its value but that's not the issue right now.

I don't know how the original broker ever arrived at the $4.5 million figure, but of course that's water under the bridge... I do know how my valuation was calculated and I am very comfortable with the process... Could my valuations vary by plus or minus $100,000 to $200,000 in either direction, of course they could, but they would still be dramatically below the $4.5 million range everyone has been tossing around. Anyway, I did the valuation, but it is up to the owner to present this to the former partners to see how more realistic valuations can be used in order to repurchase their interests in the business.


Blogger John said...

John I love your now blogging about print and your other "interests". Welcome aboard.

Of course your blog is better written and the spelling and grammar are far better than my blog

I hired John last winter for the merger I am about to close.

The final deal was within 5% of his numbers. My offer was over 30% below the asking price. The buyers and I were able to see the values John came up with and make a deal based on that. Anyone buying or selling should get his book and read it front to back.

It is sad to see what happened to his client. I see this often in family deals, the parents want to "give' the business to their kids but end up saddling them with loans to finance their retirement with a bloated purchase price.

August 10, 2008 at 11:32 AM  

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