The Business Valuation Trap: Why 99% of Entrepreneurs Are Unknowingly Overestimating Their Company's Sale Price (Do THIS Instead)

The episode clears up valuation myths, covering valuation multiples and discounted cash flow. Wayne Zell and Ryan Berry discuss business valuation’s role in sales, the effects of customer concentration, reasons valuations can be costly, key value drivers for lower- to mid-market firms, and the importance of strong management. They also cover strategies to boost valuation and close with McLean Group contact info and a teaser for future episodes.

Key Points

• A defensible professional opinion of a business's worth at any point in time is crucial for making informed strategic decisions.

• Understanding key value drivers such as customer concentration, revenue visibility, and management team depth can significantly impact a company's valuation.

• Building a management team that can run the business independently and focusing on recurring revenue streams are essential strategies for increasing a company's value before an exit.

Timestamps

0:00 Introduction and Ryan Berry's background

1:38 What is business valuation and why it matters

3:18 Knowing your business valuation before selling

5:12 Common misconceptions about valuations

7:33 Understanding valuation multiples

10:02 Discounted cash flow analysis explained

13:08 Customer concentration and its impact on value

17:28 Why valuations seem expensive

19:35 Key value drivers for lower to mid-market firms

21:26 The role of management teams in valuation

24:52 Strategies to increase your business valuation

25:45 How to contact the McLean Group

26:40 Closing remarks and future episode teaser

Quotes

"It's best to think of a valuation as a strategic planning tool, a management planning tool."

- Ryan Berry

"Filling the value gaps, the valuation that you perform today will show them that it's worth x. And if they wanna get to y, which is x plus, they're gonna have to do some stuff to clean up the business or to fill those value gaps."

- Wayne Zell

"You have to wear many hats in the beginning as an owner, as an entrepreneur, and but as the company grows and as it evolves, I think an important thing to do, and this is hard for a lot, so it's easy, definitely easier said than done, but to, you know, start giving over some of those key accounts to, you know, other members of the management team."

- Ryan Berry

"Building out that management team and then being able to, you know, run the business with as little, you know, day to day sort of oversight as possible is really the goal."

- Ryan Berry

Transcript

Wayne Zell: Welcome to Blueprint for Wealth. I'm Wayne Zell, and with me is a special guest. Today with me is my special guest, Ryan Barry from the McLean Group. Welcome, Ryan. Welcome to the show.

Ryan Berry: Thank you so much, Wayne. It's great to be here.

Wayne Zell: Yeah. Ryan is the managing a managing director of the McLean Group and heads up the firm's valuation advisory practice. So he's got a lot of experience. We work with him closely on a variety of client matters. He spent over twenty years of financial and accounting experience and has performed and overseen thousands of valuation engagements.

And I can tell you some of them are pretty hairy. So it's good. It might be involved with an M and A transaction. You might be involved with gifting transactions or things that affect the estate tax. You do all these things.

So you you earned your BA in economics and and got a minor in technology from UVA, which is my my alma mater. So it's good to know that you went to another friendly school and you also received your MBA from Johns Hopkins at the Cary School of Business. So, he's very very astute in this area and he's accredited in business valuation through the AICPA as well as being a CPA in Virginia. So, Ryan, the first question that always comes up on our screen is, you know, it's kinda crazy, but, you know, what is a valuation? What is a what is an appraisal?

How would you how would you answer that?

Ryan Berry: Yeah. No. That's that's a good question and one that we get often as well. I would say sort of in simple terms, it's a a defensible professional opinion of what the what a business is worth at any point in time. And I think the defensible part is pretty important because, you know, a lot of times it might be someone, hey, my buddy sold his business for a few million dollars, so that's probably what my business is worth.

Or it's, I heard the multiple in this industry was this, and so that's what mine would be as well. But when we're talking about defensible, it's thinking through supporting it with evidence going through certain procedures and approaches and sort of documenting those that analysis. And there's always, you know, there's always an art to it as well. I wouldn't sit here and say it's purely, you know, science. There's there's some art to it as well.

And that's where professional judgment and everything, you know, comes into play. And then I should also say at any point in time, that that part's important as well, because, you know, a valuation is, you know, we say it's sort of like a balance sheet, it's as of a certain date and time. And, you know, as we know from the markets and everything that, you know, it can shift wildly in a short amount of time. So, yeah, and in simple terms, I guess that's what I would say would say when I I get asked that question.

Wayne Zell: Why should a business owner care, about what their valuation is before they're ready to sell or raise money? Aren't they gonna just wait for the buyer to come in and tell them what the business is worth?

Ryan Berry: Yeah. Yeah. Good question. So there's a there's a few things that occur, and I won't get, you know, too far into this, but sometimes you need one just for, you know, regulatory or compliance. And Wayne, you touched on it in the beginning, you know, if it's gifting or estate planning, there's certain things like that that come up prior to a sale that you might want to do where you would need evaluation like where it's required.

But we won't focus on that right now. Know, if if it's more just, you know, hey, I've got all that stuff in order, you know, why would I need one prior to a buyer approaching me? And we like to say, you know, it's best to think of evaluation as like a strategic planning tool, a management planning tool, in that, yeah, at the end of the day, there's going to be a, you know, a conclusion of value, but what's within that report can be extremely helpful and useful to an owner or to a management team. It's really sort of identifying, you know, what things are driving value, what are some of the weaknesses, and if a owner uses that to sort of, you know, fix those weaknesses or address those gaps, you know, two to three years out from a potential sale, that can be, you know, really beneficial for them and drive value as they approach their exit.

Wayne Zell: So filling the value gaps, the the valuation that you perform today will show them that it's worth x. And if they wanna get to y, which is x plus, they're gonna have to do some stuff to clean up the business or to fill those value gaps. Right?

Ryan Berry: That's right, exactly.

Wayne Zell: So, you know, I get this question all the time from the entrepreneurs I deal with because I don't do valuation work, but I work closely with you and others that do. And what would be the most common questions or misconceptions rather that you hear from entrepreneurs when they first talk to you about doing evaluation for them?

Ryan Berry: Yeah, I think, you know, one of them that we often get is I think there's some trepidation sometimes about the especially if they've heard of, you know, if they've been through an audit, let's say, or if they've been through an M and A process, the types of documents that's going to be required. Like how long, what is going to be the effort on their end? Know is it going to take, is their CFO going to be spending the entire time or is the owner themselves going to be spending hours upon hours like you know coming up with 100 documents that are going to be requested? And we always try to, you know, alleviate those concerns of, hey, for evaluation, yes, we're going to put together a request list for you, but it's going to be much more trimmed down than what you would expect. You've been through an M and A deal, you heard about someone going through an M and A deal, it's not a 100 or more requests.

We're going to ask for some historical financials. We're going to ask for maybe a breakdown of revenue by customer or contract. We're going to ask for if you have a budget or a forecast. Great. If you could send that, you know, those types of things.

It's probably going to be a dozen or so requests. So that's one thing we try to make clear that this is we do not want you having to put together a bunch of documents just for the sake of evaluation. Give us what you have. We might ask some questions, you know, clarifying questions, but I think that's a big one. And the other one we kind of already touched upon in that, you know, maybe coming in with some preconceived notion of what the valuation multiple should be and really trying to walk through, okay, you know, that's a good data point, and I think, and it could be, it could be a very useful benchmark in the analysis, but we still need to go through the full valuation and really go through, you know, all the details to get a solid valuation conclusion.

Wayne Zell: So let's let's say the owner comes to you just like you said earlier because this happens all the time. Right? I mean, you get this question. I get this question. They say, well, my buddy, he's a tech he's got a tech company or he does software development or whatever.

And his company, which had, you know, 15,000,000 of revenue, which mine does, sold for eight times earnings before interest, taxes, depreciation, amortization, EBITDA. Why can't I use the same multiple? And so the question is, can't I use that multiple?

Ryan Berry: Yeah. Or Yeah. Yeah.

Wayne Zell: What what would you say in response to that question?

Ryan Berry: Right. No. And we get, yeah, we get those exact types of of questions and Yeah. I always do say like that is good to know and that's useful. And we'll do, you know, some of our own research on comparable M and A transactions because that's one of the analyses under the market based approach that's used for valuation.

But what we really need to do and what's interesting a lot of times, and you said these are sort of, you know, could seem like mirror image companies, right? Like exact same revenue doing the same things. But what's interesting is that there can be some fund that you wouldn't, you know, some fundamental differences that you wouldn't see just by looking at the financials. Excuse me. And, you know, that could be something like revenue visibility, you know, it could be, you know, customer concentration.

There's these some really important value drivers that could be different between the companies that would lead to significantly different valuation multiples. Yeah. So that's what interesting, and you don't really know it until you really start digging into it and asking the questions and everything else.

Wayne Zell: Let me give you let me throw some facts at you and then you respond. Cause I think you've raised those issues, and I just want to explain it a little bit better for the entrepreneurs who don't understand this. First of all, the methodology that you use, it's discounted cash flow analysis, right? And so that's one of the methodologies that you use. And how do you come up with the the the metrics to determine what a little company's or a big company's discounted cash flow is to figure out what its fair market value is?

What are you looking at? You're looking at historical, projected. I mean, how do you come up with that number, first of all?

Ryan Berry: Yeah. Great question. So first of all, you know, one of the the items that we ask for if a company has it is is a budget or forecast because we want to see sort of what management's looking at, where they think, you know, the company's headed, where it's going type of thing. And a big part of that discounted cash flow analysis, as you mentioned, and that falls under what we call the income based valuation approach, this discounted cash flow analysis that we do. And a big part of that is that first word discounted because we look at the projected cash flows of the business, which is important, but we also have to take into account the fact that those aren't, you know, for sure happening, right?

There's a risk there. So we have to address that risk. So we come up with the risk rate for the company or what's called the discount rate than to discount, to risk adjust those free cash flows back to the present day. And that's where we look at, you know, see what the company is projecting as far as revenue growth. That's one of the the big things, and I touched upon it earlier, revenue visibility.

How much of that is, no, maybe it's already under contract, maybe it's all go get revenue, you know, that's going to change that risk factor a lot. It's also looking at the historical financials. How has the company performed historically? Is this going to be a big stretch based on what they've done the past several years or not? And sometimes it might be justified.

Maybe the company just won a major account and that's going to double the revenue and that would seem risky on the surface. But if you knew that they had just signed ink that contract, then you wouldn't have that, you know, as much risk. So it's those are some of the things that go into the the discounted cash flow analysis. And we do have to build up that risk rate, the discount rate for the company with a number of different factors. So that's a really important part of the analysis, know, in addition to market based approach, because it takes into account a lot of those factors, a lot of those unique attributes of the company that maybe aren't as used as much in a market approach where you look at valuation multiples.

Wayne Zell: Yeah, I mean, that's a really good explanation, thank you. One of the other items you raised in our earlier discussion was customer concentration. So let's say you've got a company that's got 15,000,000 in revenue, and it's being generated by two customers. And you got the other guy who lives down the street who has 15,000,000 in revenue.

Maybe it's the same industry. Maybe they're they're doing the same thing. But he's got 15 customers, and no one customer amounts to more than 10 or 15%. How does that factor into your analysis? Because I would think that the guy with the two customers is not gonna get the same price or valuation that the guy with the multiple customers would have.

Ryan Berry: Yeah. Definitely. I think the the concentration issues is something that we document in, every report that we're doing. We look at customer concentration, contract concentration a lot because as you said, know, if it's especially if there's, you know, if it's customer concentration and, you know, we're talking sort of one decision maker, you know, and if that person retires or the relationship's hours, you know, the fact that it could go away that quickly is a major risk factor. So a company that's more diversified with their customer base, you know, and or contract base, all else being equal, would be, you know, have a higher valuation.

Will say though, you know, sometimes we occasionally look at, you know, there's there are, you know, it's sort of few and far between, but sometimes buyers might see if the company is entrenched with two customers that are very strategic and could, you know, there could be a lot more potential upside rather than 15 customers which are all, you know, don't have as much growth potential. You know, sometimes it could be seen as a value driver. So it's interesting, you know, you really sort of have to dig into those details.

Wayne Zell: Thank you for for pointing that out because I think that's a really important factor. I mean, what do those 15 customers consist of? What do these two customers consist of? And what's the buyer looking for? You know, because they may, those two customers may fill a gap that the buyer needs to fill to make them more valuable.

And that, I think, is, you know, again, it's not just how many customers do you have and how are they diversified. It's also what are the customers and what's the guarantee or the likelihood of generating this revenue going forward? And what's your history with these customers? And, you know, if you just got in a big new contract, that's great. But is it really worth, you know, increasing the valuation significantly even if it's inked?

So, you know, there there are lots of questions that come up in this context, and you guys have to wrestle with that and make some subjective decisions on the risk of generating this revenue going forward and then discounting it back to the present. So I think that's it's it's a very complex field, valuation analysis is, and I don't think people give it enough appreciation. One of the, you know, questions we always get from entrepreneurs, and and this is, I think, it's, you know, penny wise pound foolish, is, why is a valuation so expensive? Aren't you just cutting and pasting the same information from your other 50 or 100 page report into this report? Why do I have to pay $1,520,000 or more for evaluation for my company?

It just doesn't make sense to me, and I know there's a good answer for that.

Ryan Berry: Yeah, yeah. Hopefully, anyone asking that question will watch these first, you know, few minutes of this conversation because it really does, as we've touched upon, you know, there's only so much you can get from just looking at the financial statements and trying to make some, you know, judgment calls, you really need to dig into those value drivers and ask questions and, you know, the follow-up questions to really understand those risks. I think that's so important, you know, we're peeling back the layers of the onion and we're I think it's something where there's a lot a lot to be discovered about the company that's not, you know, evident from those, you know, historical financial statements. So it's a lot of research and analysis that's really going into it. And, you know, it's, you know, a good amount of that research and analysis.

And I know sometimes the analysts that I work with will say this, it feels like, you know, they spend a lot of time with stuff that's not and, you know, doesn't end up being in that, you know, in the final report. And my comment back to them is always, you know, it's always worth it. You have to we have to go through and do the analysis until you, you know, do all the research and all the analysis. You're not gonna be completely sure about, you know, or feel completely confident about your valuation conclusion.

Wayne Zell: What are some of the value drivers that really drive the value of these lower to mid market firms that you are dealing with?

Ryan Berry: Yeah. I I we we talked about two of them already, which I think are important, and there's another one that I'll mention. But those first two, which we've already touched upon, the concentration, I think that's, you know, really important. Revenue visibility, we didn't talk about it as much, but it's a term we use a lot when we're analyzing a company. So looking at, you know, how much of the of the revenue is from, you know, if it's if it's under contract, if it's, you know, known or how much is from a customer that has a track record of, you know, that you've generated, you know, x, you know, hundreds of thousands or millions of dollars from over the last several years.

Wayne Zell: Recurring recurring type revenue. It's not really

Ryan Berry: it may not be recurring

Wayne Zell: revenue. Yeah.

Ryan Berry: Exactly. Yeah. It can mean different things in different industries. I mean, the the SaaS, right, the software, you know, as a service industry, that's that's why those, you know, companies have such high multiples because if you can show that you have those types of net retention rates that some of those companies are, you know, 100% or or more, they, you know, command some pretty high some pretty high multiples. That revenue visibility is something that we see buyers looking for a lot.

Wayne Zell: How about the management team?

Ryan Berry: Yes. So the, you know, something, and this sort of goes along with it a little bit, is key person reliance. So management death and key person reliance, you know, it's especially with small companies, you know, easier said than done, right? Because you have to wear many hats in the beginning as an owner, as an entrepreneur, and but as the company grows and as it evolves, I think an important thing to do, and this is hard for a lot, so it's easy, definitely easier said than done, but to, you know, start giving over some of those key accounts to, you know, other members of the management team, and the ultimate goal should be that the business can almost run without you eventually. Because we've seen it from buyers, right?

What are they thinking about when they're going to buy a company? How important It's great that that person is so important and they've been able to build that business, but ultimately it's gonna have to run without them. Right? So I think building out that management team and then being able to, you know, run the business with as little, you know, day to day sort of oversight as possible is really the goal.

Wayne Zell: I think that's a been a huge value driver for a lot of my clients. I've got a lot of older folks, baby boomers who are trying to sell their business or transition their business, and I don't think they realize how important they are to the business. And if they were taken out of the equation, that the business would be devalued significantly. And so that's why having a team below you or next to you that can function and run the business without you and still continue generating revenue is absolutely a critical value driver that most people just ignore. But, thank you for bringing that up.

You know, we we talk about higher valuations. You know, one of the things I do as an exit planner is try to make sure that the the client, the entrepreneur, has enough money at the end of the day if they sell their business that they can live on it comfortably the rest of their lives. If they live till they're 80, 90, 100, 110, whatever, whatever their projected life expectancy is and however long they want to plan for. But when I get financial planners involved, I want to make sure that the entrepreneur is taken care of. So I say, okay, this is what you're gonna need.

This is what you may want. How does the business factor into this? So if I know that I'm I'm short because you did evaluation for me today and it said, well, the company is only worth 5,000,000, but we need to get you to 8,000,000 so that after tax, you've got enough to live on the rest of your life. If a listener, an entrepreneur, wants a higher valuation three or five years from now, what are the two or three things that they should start doing now to take care of that value gap? What would you say to them if they sat down with you and they said, oh, I thought my business was worth a lot more.

I thought it was worth eight times. It's only worth five times my earnings. What do I do to get there?

Ryan Berry: Yeah. I think, you know, some of them we've touched upon already and maybe even the last one, you know, being the most important is spend the time now building out that management team and making the company less reliant on you. I think that's really important. I think also the earnings, like maybe choosing earnings quality over earnings quantity and sort of what I mean there is that, you there's a, you know, you can sort of chase the maybe one time, you know, non recurring revenue, you know, as it presents itself and maybe it, you know, might lead to some, you know, big years, some, you know, years that pop and then come back down, and so it's a little, as they say, lumpier. Whereas if you're, you know, have a, you know, strategic direction of trying to go after more recurring work, and that's going to maybe tell a better story and show, you know, maybe more maybe not as, you know, quick as a pop, but a more consistent growth across the years, I think buyers are really gonna put a higher a higher multiple on on those types of earnings.

So it's, you know, it's

Wayne Zell: recurring earnings Yep. Or recurring revenue rather. Yep. Obviously, keeping your your costs in check because if you're generating a lot of revenue but your costs are eating into your profit and you don't have any profit to show, then that means you don't have any cash flow from the business sufficient to justify a high valuation. Right?

Exactly. And then number two, the the management team. Yep. You know, we've gotta make sure that we've got a succession plan lined up for the founders. And if they don't think about that sooner rather than later, they could be caught in an unexpected event and the business wouldn't be worth what they had hoped.

And so you do you all get involved in, analyzing this for clients and giving them advice on how to fill the value gaps?

Ryan Berry: Yeah, we do. A lot of times and sometimes we, you know, look at a valuation that is also it's a different type of product, but more like an exit planning type of product where we, the other side of our business is M and A advisory. So a lot of times we bring those guys in to think about, you know, different potential exits and what they do and, you know, what the entrepreneur would have to do to get there. Right? Like, this is the valuation.

This is where you are today. We've identified some gaps. What are some ways you can go about fixing those, filling those gaps so that you can get to this exit you want to get to down the road. Yeah.

Wayne Zell: Well, that's this has been very illuminating for me as well as for the listeners today, for the entrepreneurs, hopefully, that are listening today. If people want to get in touch with you and the McLean Group to help with valuation work, whether it's a four zero nine a valuation or an estate planning valuation or an m and a strategic valuation, How do they do that? How do they find you?

Ryan Berry: I guess the easiest way would probably be to go to our website, mcclainllc.com, and you can find me there on the team page. It would probably be the easiest.

Wayne Zell: Well, I can I can attest for the expertise that you bring to the table on the valuation front? So we really greatly appreciate the time that we've spent, with you working with clients, and I hope, some of the entrepreneurs that are listening today can, reach out to you as well. So thanks for being a special guest on Blueprint for Wealth today, Ryan.

Ryan Berry: Well, thank you so much, Ryan. It was a pleasure.

Wayne Zell: Thanks. And for the rest of you, stay tuned for future episodes of Blueprint for Wealth, where we're gonna feature special guests that are hopefully gonna give you value that you can realize in your future endeavors. Thanks. Have a great month.