Using Your Neighbor’s Valuation is a Lot Like Borrowing Their Shoes
I will give you a minute to get over the “ewww” factor involved in wearing someone else’s shoes.
Often, I meet with business owners for an initial consultation where they arrive with a value for their business in mind. Usually, this is a result of having sat at a bar (country club, airplane, basketball game…) with a friend or neighbor that had sold their business, hearing the multiple of revenue or EBITDA that person received, then multiplying that number by their own revenue or EBITDA. Voila! There is your business valuation.
There are a few things that are wrong with this rampant, back-of-the-envelope valuation practice.
First, on an emotional note, your friend probably exaggerated. Similar to describing one’s last round of golf, high school basketball career points, or the size of that muskie pulled out of the lake up North, the value received for the sale of a business tends to be one of those things that people inflate in their minds, and later, their words.
Secondly, the multiples change. I know this seems obvious, but if I hear another person say “technology companies trade for 4 times revenue,” I’m going to have to throw my computer at them. Maybe they traded for that last year, maybe last week, maybe in 1985. Unless you are taking companies exactly like yours to market constantly, private business owners cannot know what the market is paying right this moment. Whatever multiple you are looking at, I can guarantee that your number won’t be that number. Things change constantly.
Thirdly, companies are different. To use a Millennial turn of phrase, “they are like snowflakes.” I can make a long list of things that buyers pay more for in a business and another that detracts from business values. Maybe your friend had excellent gross margins, a diverse customer base, a rotten ERP system, two broken machines, and a rock star management team. Do you have all those things? I’m guessing you do not. (If you do we need to address the broken machines and the rotten ERP system before you sell). You get my point. Of course, your revenue and EBITDA are part of the valuation, but they are just one part. There are a lot of company characteristics that go into valuing a business.
An investment banker or business advisor who can evaluate your business in the context of the current market is the only way to know the real value of your business. You need someone that is selling businesses often because they are the only ones that know who is paying what for what.
Onto the shoes. Your neighbor probably has nice feet, but maybe he has a bunion or two that he’s not telling you about and sometimes he doesn’t wear socks. His shoes are stretched in weird places and they are the wrong size for your feet. Get your own shoes.