For most entrepreneurs, their business isn’t merely the organization they’ve founded, managed and grown en route to carving out a lucrative niche in their market—it’s also one of the key components of their personal wealth. Driving the valuation of that company, therefore, isn’t merely a strategic goal, it’s key to building their net worth and achieving financial independence. It’s how many will build a lasting financial and professional legacy.

The drive to boost corporate worth can also lead to significant overestimates of an organization’s value. A company’s valuation will be determined by a range of data points and analysis that may not align with a business owner’s perception and can be skewed by a number of factors. Of course, sometimes, the opposite is true. The bottom line is that an organization’s market value may be significantly higher or lower than what the owner, leadership team or investor(s) expects.

Understanding what that number is can be an important part of developing a long-term operations and growth strategy. But according to a 2022 survey of U.S. business owners by M&T Bank, 98 per cent of small business owners lacked an accurate (or at times even rudimentary) sense of their company’s value. Based on our  experience, it’s fair to say that the percentage would likely be similar for Canadian entrepreneurs.

Having a reasonable sense of your organization’s value is crucial at all stages of the business life cycle. So, too, is knowing why business valuations can be overestimated—and how to avoid over-valuation pitfalls. Here are some of the most common reasons why entrepreneurs believe their company is worth more than it is:

Emotional estimates—Years, perhaps decades, of hard work, financial and personal sacrifice, innovation, customer rejection, customer success, long hours—these are factors that may create a false perception of a company’s worth relative to the market. However, potential purchasers or investors, while all likely aware of the sweat equity needed to build the company, primarily care about the financial and/or strategic benefits it will provide them post-acquisition.

Market condition misreads—When a home is sold in a neighbourhood, it tends to set a bar for all the other homes up for sale in that area. The same can be true for a business that attracts acquisition or investment interest. Other organizations in that sector can benefit (or suffer) from a competitor’s valuation. However, like a residential property, which has a value based on factors ranging from the size and the quality of the property to the finishings and square footage, many subjective factors contribute to a company’s valuation—including the quality of the leadership team, the scope of its product or service offering and competitive forces that impact its growth potential. A business in a declining sector, one that faces formidable competition or that may be intrinsically tied to the expertise and involvement of its owner-operator, may generate a significantly lower valuation than anticipated.

Ignoring balance sheet realities—Business owners are astute and have a deep understanding of the day-to-day finances of their organizations, along with the competitive landscape. But it’s still common for many to overweight their company’s gross revenue when estimating the company’s valuation. Revenue may be an indicator of success, but in most cases, cash flow is king when determining a businesses’ value. Poor cash flows or profitability can have a significant negative impact on the potential price a purchaser is willing to pay.

Failing to recognize operational risks—Internal management challenges, an overdependence on key suppliers or clients, overreliance on an owner, manager or top salesperson, regulatory shifts or existential threats—think technology such as artificial intelligence disrupting entire business models—are all risk factors that influence a company’s valuation. Optimistic business owners may overlook or downplay them, but prospective buyers and investors will all assess these risks when putting a price tag on your company.

Equating growth with value—Operating in a fast-growing market—or experiencing rapid growth in a business with even greater expansion potential—can lead to an entrepreneur making unrealistic valuation assumptions. Projections must be supported by data and a thorough analysis of both internal company dynamics and market realities. If both are lacking, a buyer may discount the valuation of the business if they deem growth projections to be inflated or unreasonable.

To avoid overestimating the value of a business, owners, leaders and investors should think objectively and engage the services of a Chartered Business Valuator (“CBV”). A CBV will take a comprehensive approach to produce an accurate, unbiased determination of a company’s value. Doing so helps mitigate the risk of emotional bias entering into the equation, while also helping owners better understand their corporate financials and plan for the future.

In our next blog: Why your business may be worth more than you believe.

The RH Partners team

To discuss your business valuations and litigation support needs, contact us today.