Quick Consultant: The Peril of Unrealistic Expectations for Business Valuations

Editor’s note: All names in this article are fictitious.

The buyer made a solid offer to purchase Dave Johnson’s printing business. The buyer offered him $285,000 for the business and said he had arranged all his own financing. Dave would not have to take back any notes. The best news was the buyer could settle within 30 days.

Oh sure, there were the typical arrangements to be made, including Dave staying on for a period of time to train, but all in all it was a very clean and fair offer. At least that is how the accountant, the broker, the attorney, and I felt. We all advised Dave to accept the offer.

I will tell you more about the business in a few minutes, but for right now suffice it to say that Johnson’s Printing & Graphics reported sales of $805,000 in 2010. What about previous sales and sales trends? Johnson’s printing firm reached $1.1 million in annual sales in 2005, but then began to experience, like so many firms in this country, a slow decline in sales. Of course, he blames most of the drop off in sales to a sluggish economy. Not sure I will accept that, but I will hold most of my comments for later.

Despite the feelings of the accountant, the broker, the attorney, and the candlestick maker that the offer was fair, there was one individual who was adamantly opposed to the offer—Dave.

“I can’t believe someone is making an offer that low. It’s an insult. I’ve worked to build this business up over 14 years, and so has my wife, and I can’t believe someone is only willing to offer me $285,000 for a business doing almost $1 million in sales,” he said. “Hell, I would rather just shut the doors and walk away than to sell for that small amount.”

Some of the Valuation Details

When I heard about Dave’s reaction, I was disappointed. Dave reacted the same way as so many other owners who have decided in the past couple of years to get out of the business. They react in anger or frustration after realizing that the business they have worked so long and hard to build isn’t worth what they had been counting on for retirement.

Dave and his wife simply refused to believe the numbers we were presenting and the valuation approach we were using. Although he strongly disagreed with our valuation, Dave was unable to provide a logical formula to justify the $400,000 price tag he had placed on the business.

First, Dave kept referring to the business as a million dollar business. Well, it may have done a million in 2005, but we don’t value the business on past performance, certainly not on sales achieved five years ago. If we were to “weight” Dave’s past sales and profits—something we don’t believe in—it still could not be referred to as a million dollar business. The facts are the business is currently producing $805,000 in sales and there is no assurance whatsoever that sales will ever return to 2005 levels.

Valuing Future Potential?

Every so often during our earlier meetings, Dave would say that a new owner could easily get the business back over $1 million. “Someone with the right talents, especially in sales and digital technology, could really take this business to the next level,” Dave said repeatedly.

I kept telling Dave that he couldn’t expect to benefit from the talents brought to the firm by a buyer. In essence, you are expecting a buyer to pay you extra for the talents he or she is bringing to the table. That’s not likely to happen.

One more thing you should know. There is a difference between value and a fair market selling price. The fair market selling price is nothing more than a meeting of the minds as to what the buyer agrees to pay the seller. In almost all cases, the buyer is buying the assets of the business, less those assets retained by the seller. Buyers rarely agree to assume notes and other liabilities of the business. Assumption of leases is probably the one exception. Many buyers will agree to the latter.