The Problem with Business Valuations and Investors

I have a client who thinks he needs a business valuation. In this particular case the client is courting an investor and he would like to go to the investor with a piece of paper that says "My business is worth $x. Therefor, you should pay me 10% of $x for a 10% stake in the business. There are several problems with expecting a business valuation to meet this client's need.

1. Valuations are expensive. Depending on the complexity of the organization valuations for small businesses can range from $5,000 to $30,000. CPA's will typically perform a calculation engagement or a valuation. In a calculation engagement the client brings all the variables and assumptions to the table and the CPA pretties them up in a nice report. Not very impressive. A valuation on the other hand examines the business from many angles to assess things like expected cash flow, risk and required ongoing investment. It is a lot of work and not surprisingly we like to get paid for it. So before you spend the money make sure it is going to fit the need you have.


2. Valuations are subjective. Something is only worth what someone else is willing to pay for it. A valuation is a third party's opinion about what someone else might be willing to pay. But until someone actually pays no one can really know what the business is worth. In other words, what I think about the value of the business is irrelevant if the investor has a different opinion.


3. Investors do their own valuations. Do you really think that someone is going to just take your word for it before they hand over a couple of hundred thousand or especially several million dollars? Don't get me wrong. They'll use your valuation...for scratch paper. Investors worth having will perform their own due diligence. They will build their own valuation models and they will test their assumptions against documents you provide. Why spend the money on something they will never use?


4. Valuations age quickly. One significant shift in your business, the loss of one major account, the departure of a single key employee can have dramatic effects on the value of your business and could invalidate a previously completed valuation. Negotiations with investors, however, can drag on for months or they can be over before your CPA cracks the file folder on your valuation engagement.

My suggestion for this client and others is this: learn how to fish. Have your CPA sit down with you at the whiteboard and run you through several valuation scenarios. The most difficult part of any valuation is assessing the risk, or "cap rate" that will be used. In the end the cap rate is less important than the required rate of return for the investor. If you can sit down with your advisor and forecast cash flows under multiple scenarios you can then have a meaningful discussion with your investor regarding the required ROI. Together you and your respective advisors can evaluate the business and the likelihood that the money the investor stands to give you will enable the company to deliver a return the investor can live with. And that is much more valuable than a valuation.