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A recent article in INC magazine titled”Street Smarts,” by Norm Brodsky (his column is worth the price of the magazine) addressed the subject of the title above.  However, in the very first paragraph of the article, Mr. Brodsky stated, “Unfortunately, most of them [business owners] have grossly inflated notions of what their companies are worth.” Mr. Brodsky is not one to mince words.  Some of his examples were: “One company had lost money on sales of about $60 million, and yet its owners thought it was worth between $50 million and $100 million … Another company had a net profit of less than $335,000 on sales of about $6.5 million – and still the owners somehow came to believe it was worth between $100 million and $200 million.”

Mr. Brodsky feels that the reason for this is “… our egos can get us in trouble when it comes to putting a dollar value on something we’ve created.  We generally take the highest valuation we’ve heard for a company somewhat like ours – and multiply it.”

He goes on to point out that prospective acquirers are more concerned about profits, especially Free Cash Flow, than sales.  Too many company owners use some rule of thumb based on sales.  He also points out that company owners tend to use a comparison of a similar business across town that sold for some multiple of sales and then apply it to their company.  There are so many variables of how sales (and subsequently earnings) are generated that no two companies are ever alike.

Business owners tend to forget the negatives of their business; e.g., sales from just a few customers, lack of contracts with customers and suppliers, lack of product diversity, out-dated equipment, etc.  Also, as Mr. Brodsky points out, “Before you try to sell, make sure you know what buyers want.”

Turning to another expert voice, here is some good advice from Allen Hahn, Senior Vice President of Valuation Research Corporation: “The level of EBIT or EBITDA used for negotiating a purchase price is the ‘normalized’ level that will be available to the new owners from the assets acquired.  Often times this requires elimination of unusual, inappropriate or non-recurring expenses.  Buyers will typically consider a company’s last twelve months of financial performance.  However, projected results may be more relevant if a structural change has recently occurred in the business (loss of a key customer, acquisition, etc.) that renders historical results less meaningful.”

What does all of this mean?  It means that owners should disregard rules of thumb based on what the company across town sold for; it means that owners should not use a multiple based on what the business did four or five years ago, or what they think the business will do next year.

Business owners should first put their egos aside, then look long and hard at the company’s cash flow, realistically assess the negatives (and positives) of their business and “make sure you know what buyers want.”

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