The risk of overvaluing your business remains an ever-present shadow. Here’s what you must know about overvaluing a business and the consequences.
Today, approximately 30% of adults run a business or intend to start one sometime in the next three years.
Buying and selling businesses is all part of the process, but knowing the value of your company also has value because it shows where you are in terms of progression, and provides food for thought going forward. The risk of overvaluing your business however, remains an ever-present shadow.
Here’s what you must know about overvaluing a business and the consequences.
What does overvaluing a business mean?
Overvaluing a business means precisely what you think it means. It means overly optimistic projections as to the worth of certain assets, your position in the market, and what you believe someone else would be willing to pay for your operation.
Although it’s definitely a problem amongst inexperienced entrepreneurs, plenty of larger companies have made this fatal error. For example, the engineering company Wood Group purchased a rival for £2.2 billion in 2017. The overvaluation of its target saw its value plummet from £5.3 billion to £167 million while assuming a debt burden of $1.1 billion USD.
In short, overvaluation is a potential catalyst for future business disasters.
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What factors can inflate a business valuation?
Business overvaluations aren’t necessarily a concerted effort to mislead investors, partners and employees. On the contrary, companies often fall victim to being unable to see the forest for the trees. In short, all it takes is being overly optimistic in one area to throw valuations off track.
Note that business valuation isn’t an exact science, and this is why there’s some scope for deviation. But when businesses lurch too far in one direction, problems happen.
Here’s a breakdown of the primary factors that could inflate the value of your company.
Unrealistic growth expectations
Did you have a great year? It’s easy to get carried away, and believe you will have a great year again. However, past returns are no guarantee of future returns. There’s a big difference between a superstar startup that bucks market trends and one that grew simply because its niche experienced a favourable market cycle.
Underestimating rising costs
The UK and the world economy continue to struggle with inflation and rising prices. Downplaying your operating expenses and future capital requirements are two easy ways to find yourself with growth projections that don’t match current reality.
Ignoring the broader market
Every market goes through boom and bust cycles. Looking at your business in isolation puts you at risk of ignoring what’s going on outside your door.
Take the time to focus on your competitors, your niche and the broader market. Factor in macroeconomic issues, including:
Using aggressive accounting strategies
A company’s own accounting practices may also put the business at risk of being overvalued. Examples include:
Poor market comparisons
Comparing your business to other players in the market is a popular methodology for measuring a business’s worth, but it must be done based on genuinely comparable businesses.
For example, if you’re a small technology company, it doesn’t make sense to benchmark yourself against Apple or Microsoft. Likewise, using industry multiples based on the largest companies in your sector, even if you’re competing against them, is one of the fastest ways to overvalue your business.
The risks of overvaluing a business
Overvaluing a business is an error that can have a significant ripple effect across your firm and its standing. We can split the risks of overvaluing a business into separate categories, including financial, market, operational and reputational.
Financial risks
The financial risk of overvaluing a business is immense. Even if you attract capital based on an unrealistic valuation, you risk creating a financial bubble that eventually busts. It can also result in taking on excessive amounts of debt relative to a business’s real value.
Raising capital or attracting partners based on unrealistic valuations sets the stage for trouble as it becomes impossible to actually follow through on the picture you’ve created through an overvaluation.
Investor risks
An overvalued company will also affect any investors you’re working with. Investors may withdraw their support over the issue. Likewise, suppose you’re running a publicly traded company. In that case, you risk a sharp decline in the firm’s market value as reality emerges, and it’s a hole the business may never recover from.
Plus, businesses that misrepresent their value significantly enough—intentionally or unintentionally—may expose themselves to regulatory scrutiny and legal action.
Operational risks
In an operational sense, your usual day-to-day processes are also impacted when you overvalue your company.
Many companies rightly commission valuation reports to support future decision-making. An incorrect valuation potentially sends you in the wrong direction. For example, if your company is overvalued, you may opt for a policy of aggressive expansion, which could put you at risk of taking an unsustainable direction.
Reputational risks
Reputations take years to build and only minutes to destroy. Businesses making boastful claims place the trust they’ve curated on the line. Whether that’s an investor, supplier, or a customer, an overvalued business could damage your company’s long-term relationships.
Moreover, it may lead to fallout at the leadership level. With the very real risk of an overvalued business causing financial distress, this can create chaos in the boardroom as your credibility cracks.
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How to reduce the risk of business overvaluation
Business overvaluation begins with the data you’re basing that valuation on. Reducing the risk of business overvaluation starts with creating a process whereby the numbers are accurate and defensible.
However, valuations go far beyond the numbers you hold in your ledgers. Entrepreneurs have a habit of overestimating the worth of non-tangible assets, including copyright, goodwill and intellectual property. Moreover, they may play down the successes of their competitors or turn away from the risks bearing down upon them.
In other words, the best way to reduce the risk of overvaluing your business is to work with an outsider who can take a genuinely objective position. Choosing the right agent is difficult, which is why turning to a reputable brand is crucial.
At Hilton Smythe, we possess decades of collective experience supporting and guiding businesses in obtaining realistic company valuations. To learn more about how we can help you get a valuation you can rely on, speak to the team today.