As a business owner looking to sell your company, you probably have a figure in mind of what you want (or need) to get from the sale. This figure is essentially what you think your business is worth. On the other hand, buyers have their idea of what your business is worth. Odds are, these figures are not the same. The delta between the two figures is known as a valuation gap, or value gap, which has derailed plenty of middle-market deals.
The 2020 Private Capital Markets Report contains a telling statistic — the number one reason for business sales not closing in 2020 was the valuation gap.
As a prospective seller, it’s imperative to understand what a business valuation gap is, factors that contribute to the valuation gap, and the role it plays in selling a business.
What Is a Valuation Gap?
A valuation gap is the difference between what the business owner wants or needs to get from the sale of a business, versus the market value of the business (i.e., what a buyer is willing to pay).
Valuation gaps are rather unilateral. For instance, if you’re looking to get $3 million from the sale of your mid-market business and a buyer comes along and offers you a $4 million purchase price, you’re likely going to accept pretty quickly. In these cases where sellers undervalue their company, differences in valuation won’t hold up deals.
On the other hand, it’s far more likely that the seller’s perceived market value is higher than the buyer’s — this will end up with a selling delay. If you’re looking for $3 million from the sale of your startup and buyers are only offering $2 million, you’re not going to be as quick to sell.
When you consider that 98% of business owners don’t know their company’s value and that only 20—30% of businesses that go to market end up selling, it’s clear to see how critical the value gap is. Let’s take a closer look at why the valuation gap exists and how it plays a role in mergers and acquisitions (M&A).
What Factors Contribute to the Valuation Gap?
There are a few factors that contribute to a valuation gap. For one, you have what the business owner “wants,” which can often be subjective. In this scenario, the owner may get stuck on a number without following a specific methodology or considering technical measures like cash flow, liquidity, or earnings before interest, taxes, depreciation, and amortization (EBITDA).
Rather than getting a professional business valuation, the owner may want to receive a certain payout and won’t consider anything less. The fixation with a subjective number is referred to as emotional capital, as it’s often representative of the blood, sweat, and tears that the owner and management team have put into growing the company.
Another factor contributing to the valuation gap is that the owner wants the sale to reflect future growth. If the business is being sold while it’s on an upswing, the owner may want the selling price to correlate with future profitability and growth rates. There may be a gap based on what the business is worth today (what buyers will pay) and what the owner thinks it will be worth in the near future.
Lastly, an owner’s subjective opinion can be a contributing factor to the value gap. Perhaps they haven’t quantitatively measured the value of their company. Maybe they haven’t crunched numbers to understand cash flow from operations or margin strength. Or, maybe there are other competitors in the market, meaning the company is not nearly as “niche” as the owner thinks.
What Role Does the Valuation Gap Play When Selling a Business?
Usually, the sale price of a business is what derails M&A deals. The sale of a business is a major liquidity event for the owner(s). Sellers often want or need a certain amount of money to live on or reinvest for their post-sale life. If they can’t achieve that, they may feel like selling the business isn’t “worth it.” Whether real or imagined, a number of factors contribute significantly to why the valuation gap exists with M&A deals.
Let’s say an owner needs to sell the business for $5M so they have at least $2.5M to add to their retirement account after all fees, taxes, and liabilities have been paid. In this situation, the value gap becomes even more critical as the owner may not be able to afford to sell the business at its current valuation.
If they want to reach their goal value (sometimes called a destination value), they will need to keep running the business — and manage it in such a way that the value increases.
In other words, they have work to do.
Not having a proper business valuation from an M&A advisor or valuation expert can lead to serious disappointment when selling a business. The owner was expecting to sell after years of hard work, only to now realize that they must keep working for a couple of years for a sale to be possible. If they had done their due diligence ahead of time and known the value of their business before going through the M&A process, they could have avoided this situation.
If you’re a business owner nearing the age of retirement, you may be feeling close to “done.” You’ve put enough into the business and it’s time to pass the torch. Are you willing to work as hard for the next three years as you did the first three to help close the valuation gap? You may not be at the point in your life where you want to dedicate the time or effort to do so.
The valuation gap plays an incredibly important role in M&A transactions. Preparing ahead of time can prevent unwelcome surprises when you are finally ready to sell your company or retire.
What Are the Best Ways to Minimize a Value Gap?
If you’re a business owner considering selling, the valuation gap is perhaps the single most important factor for you to consider before getting started. Here’s what you need to know.
1. Get a business valuation today
Don’t wait until you’re ready to sell to get a business valuation. At that point, it may be too late. Start planning at least one to two years in advance. You need to get an idea of what buyers will pay to see if there’s a valuation gap. If there is, then you have time to address it. A business valuation will help you make decisions about managing your business in a way that will increase its value rather than erode it.
2. Work with a financial advisor to see how your proceeds will impact retirement
If the sale proceeds are part of your retirement plan, work with a financial advisor to understand how the sale of the business fits in with all the other assets in the plan. The advisor will consider factors such as your:
- Current portfolio, growth stocks, and investments
- Interest rate on cash reserves
Planning ahead of time allows you to better determine how much money you’ll need for retirement and how your proceeds will impact your bottom line.
3. Start working with a business broker or M&A advisor
Work with a business broker or M&A advisor sooner rather than later. They can help you understand what your business is worth to a buyer, and how to either:
For example, one such solution to overcome a valuation gap is to implement an earnout. With an earnout agreement, the seller will get the difference (gap amount) paid out as the growth is realized by the business under new ownership. Business brokers work to implement these terms into contracts and get you the best deal possible when selling.
Valuing Your Business Today Creates a Roadmap for Your Future
The valuation gap is the most challenging hurdle to overcome when selling a business. Whether it’s because of an emotional attachment, a need to raise capital, or a combination of these factors and others, owners often feel their company should be valued higher than what buyers are willing to accept as the purchase price.
Unfortunately, most business owners have no idea what their business is worth. The valuation gap is one reason why it’s crucial to track this metric now.
Sitting with a financial advisor and business broker can help determine your true business valuation as well as the steps you can take to maximize returns from your sale. At Allan Taylor & Company, we’ll work with you to put you and your company in the best position for a sale.