[View Article List] [Go Back]

Seven Business Valuation Errors to Avoid

Business valuations can be critical to small-business owners. That is why great care must be taken to avoid errors that may hinder the process. The following are seven common pitfalls to watch out for.

1. Failure to include all business assets: There are certain formulas and methodologies often used to value a small business. It must be remembered that such valuation methods may not consider all assets of the business. Similarly, the calculation of goodwill, which is often complex, may draw attention away from the need to properly account for other assets and liabilities.

2. Inaccurate application of multiples: Valuation methods use income multiples to determine goodwill. For example, goodwill may be a multiple of the company’s earnings. However, to properly compute goodwill within a particular industry, the analysis should be based on either after-tax or pretax earnings. The difference may be significant. Also, in applying valuation methods that use a multiple of gross revenue, the appraiser should avoid inadvertent use of a multiple of net income or use of income where cash flow is required.

3. Omission of minority discounts: The valuation should reflect the existence of minority shareholders. For example, take two hypothetical companies—let’s call them ABC and XYZ—that have comparable sales and profits. ABC is wholly owned by a single shareholder while XYZ has ten principal shareholders. If each company is valued at $50 million, it would seem that each interest in XYZ would equal $5 million. However, those interests should be discounted to reflect the dilution of control.

4. Failure to reflect unique events: A common practice is to average the recent income and expenses to arrive at an average net income. This can form the foundation for the goodwill calculation. In calculating goodwill, it is generally advisable to eliminate unusual income and expense for the company. Reason: The valuation is intended to provide a value for the business without the effect of unusual events which might cause temporary fluctuations in the market for the goods or services.

5. Failure to adjust for risk factors: A common goodwill calculation incorporates a determination of the business’ excess income as well as an assessment of whether the excess income is likely to continue. For example, an appraiser may be valuing a law practice using methods that are perfectly appropriate to such valuations, but the result will be inaccurate if the practice is unusual in nature (e.g., it generates most of its income from a unique referral source).

6. Omissions of assets and liabilities: Certain assets and liabilities might be passed over because of their nature. One example is “work in progress.” Work in progress is a form of accounts receivable for services rendered where invoices have not yet been issued. For certain businesses, work in progress can form a substantial portion of the accounts receivable (e.g., for a construction company). Similarly, another asset that might be overlooked is the value of a lease.

7. Emphasis on theory: Finally, valuations may be based upon complex theoretical assumptions. When the same business is valued from a practical “real world” standpoint, the numbers may differ. A better valuation is one that represents the amount the business could be sold for in the prevailing market. Complex theoretical analysis is rarely the basis for determining true value.

It is recommended that you obtain a valuation for your business bereft of these common mistakes. Our firm can provide the necessary assistance.

[View Article List] [Go Back]