Perception vs. reality: What’s the value of a business interest?
A business interest’s value is more than just a number to its owner. It represents years of hard work, sacrifice and investment. Owners often believe they have a clear understanding of their company’s worth. But emotions and optimism about future earnings can cloud their perception. Let’s look at psychological factors that may affect owners’ value perceptions — and why the numbers might tell a different story.
Personal circumstances may affect value perceptions
Business owners often excel at estimating competitors’ values but tend to overestimate their own companies’ values, largely because that value is tied to their personal net worth. However, an owner’s skills, reputation and experience may not be transferable to a third-party buyer — meaning the business could be worth less than the owner anticipates.
Moreover, some owners estimate business value based on personal financial needs rather than objective market data. For example, an owner who needs $5 million to retire may arbitrarily assume that’s what the business is worth. A more reliable approach would be to independently value the business and then compare the valuator’s conclusion to the owner’s retirement needs. If the business is worth less than the owner needs, he or she may have to delay retirement or explore other financial strategies and resources to meet those needs.
On the flip side, some owners intentionally undervalue their companies. This might happen, for example, if an owner is getting divorced or buying out another owner of their business. Owners in these situations have a financial incentive to downplay the value of their interests.
Valuation professionals use objective, market-based inputs
Business valuators focus on financial realities, not emotions or conjecture. When working with valuation professionals, it’s important for business owners to overcome the following three common valuation myths:
1. A formal valuation should confirm the owner’s opinion. Confirmation bias occurs when owners encourage valuation approaches that they believe will confirm their initial value estimates. They may also ignore or withhold information that leads to different results.
To ensure an objective assessment, owners should allow their valuation analysts to work without interference or pressure to provide a prescribed value. They should also openly share all relevant information with their valuators.
2. The valuation process is simple. Many business owners mistakenly assume that valuators use simple, predefined rules and procedures similar to accountants’ generally accepted accounting principles. This idea makes them wonder why valuation reports require so much time and effort. However, valuation is a consulting specialty that requires market research, subjective assumptions and detailed analyses.
Formal written valuation reports provide detailed insights into the company’s operations, including its historical performance, future earnings projections, and risk-based discount and capitalization rates. This information can help valuation report users — such as the seller, as well as prospective buyers and their lenders — make informed decisions.
3. The value conclusion is definitive. While valuation reports present a specific dollar figure (or range of values), business value isn’t an absolute number. Two qualified experts can analyze the same company and reach different conclusions due to varying assumptions, methodologies and market conditions. When discrepancies arise, understanding their sources is key to reconciling differences and reaching a reliable conclusion.
Reality check
Understanding the psychological side of value perceptions is essential for attorneys reviewing valuation reports and advising clients — as well as for business owners seeking an unbiased assessment of their company’s worth. Our experienced valuation professionals can help you separate perception from reality and gain a market-driven perspective on a business’s value.
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