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Beware the Valuation Mirage

I’m glad I never had to compete against Randy (not his real name). He is one tough bird. Introduced to him by his wealth planner, I am working with Randy to sell his company to a competitor who is in an aggressive consolidation mode. But before we could make much progress, I had to get some bad information out of Randy’s head.

In fairness to Randy, it’s common that a business owner comes into the process to sell their business with faulty assumptions. Sometimes it’s valuation expectations, sometimes it’s a belief that company X will buy them and not change anything. Sometimes it’s a naive hope that the transaction will be quick and easy.

As an experienced deal quarterback, it’s my job to lead my client through all pitfalls and potholes that can derail a deal. It was about to happen to Randy.

One of the most common valuation errors comes when calculating EBITDA, an acronym for earnings before interest, taxes, depreciation and amortization. EBITDA is easy to understand and calculate. But things get tricky when making adjustments to EBITDA, the most common of which are addbacks of business expenses that are one-time in nature or specific to that owner and not likely to be needed by a new owner. An example of the latter would be something like Titans tickets, a country club membership, or a car for a spouse.

In Randy’s case, we hit a ditch on the question of how to add back his compensation. His salary and benefits in 2020 was about $575,000. He assumed 100% of that would be an add back to EBITDA. Randy explained, “I won’t be around, so they don’t need to pay me $575,000.” I pointed out that the buyer would have to pay somebody to run the business, and annual compensation for that person would likely be $275,000 inclusive of benefits.

Meaning, not all of Randy’s compensation can be an addback. It is accepted practice to add back the difference between what an owner pays himself and the amount required to pay “market rate” to run the company. In Randy’s case, that addback (difference) is $300,000. But the way Randy looked at it, since the buyer is offering to buy his company at 7 times EBITDA, the “loss” of the $275,000 addback will “cost” him close to $2 million in transaction value.

Randy was not happy with this news. He had it in his mind that he could add back 100% of his compensation. Yes, it’s a tough blow to see $2 million of expected valuation evaporate before your very eyes, but in reality, that $2 million was a mirage all along. Whether Randy sells his company now or five years from now, he will confront the reality that his adjusted EBITDA will have to include compensation for a new owner.

Beware the mirage.

JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. .  He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The principles above are true, but the story, names and fact patterns are changed to preserve the parties’ identities.

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Tennessee Valley Group

Jim Cumbee established Tennessee Valley Group to help business owners fulfill their dreams for life after business ownership. It’s a mission that his 30+ year career history had prepared him well for—in addition to being an attorney, transition mediator and business broker, Jim has been a buyer, seller, and entrepreneur. His broad range of experience gives him unique insight into how business buyers and sellers can achieve their goals.

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