Most business Valuations are Unreliable.

When considering business valuations, most owners feel that they're a valuable tool. Why wouldn't they when valuations could help an owner in a myriad of situations like tax and estate planning, divorce or partner disputes, and the sale of their business? Did you know, however, that it's very common for business valuations to work against a business owner's interests in some situations? Let's unpack that a bit.

For example, valuation companies have an incentive to give an owner a higher valuation. A higher business valuation makes an owner feel happy and affirmed for their years of building a business. This results in an owner who is more likely to be content with paying the cost of the valuation. This is in contrast with a valuation that's lower than an owner's pre-conceived idea of what the business is worth. A lower valuation amount may lead an owner to feel like the valuation missed something, thereby asking for a redo of work, explanation, anger, and/or asking for a refund. Owners who feel this way costs the valuation company more money in dealing with their "customer complaints". The solution for many valuation companies? Simply keep the valuations higher. In their mind they might be thinking "the owner signed a waiver stating they know that valuations can't predict the actual value of a business, so why crush an owners dream with a low valuation?" This is one of many things we discuss on the topic of business valuations below: 1. Owner Bias and Emotional Attachment

Most advisors and valuators want the business owners' money, but not their skepticism - so it could be seen as best to offer a higher valuation to owners with unrealistic value assumptions.

Lack of objectivity in self-valuations or DIY approaches may ignore red flags like market downturns, operational weaknesses, customer / supplier concetrations, etc. leading to over-optimistic forecasts that don't hold up under scrutiny. Owners frequently overestimate their business's value due to sentimental attachment, years of personal investment, or optimism about its potential, leading to unrealistic expectations during sales or negotiations. Owners who cling to higher, unwarranted, valuations are susceptible to prolonged market time, failed deals, or legal disputes when buyers or courts challenge the inflated figure, ultimately costing the owner time and money.

2. Mismatched or Inadequate Data for Business Size and Type

Costly valuations are typically most affordable for large firms. This means it's likely that many software companies' databases have a much larger average values, for their datapoints, than the true market average. When this valuation software is used to valuate small or medium sized businesses (SMBs), the comparable company data (comps) doesn't tend to align with SMBs actual data. This is likely due to differences in scale, complexity, market position, risk profiles, etc. Additionally, industry classifications used in comps are often too broad or subjective, failing to capture the specifics of a private business, which can lead to irrelevant multiples. For some small niche businesses, lacking comparable comps can undervalue, or even miss, unique niche competitive advantages causing artificially low valuations. Data applied broadly to these niche businesses leads to incomplete analyses which could widely swing values way too high, or way too low, damaging the integrity of the valuation.

3. Subjectivity and Judgment Errors in Valuation Methods

Valuations involve high levels of subjectivity, such as selecting discount or capitalization rates, which require expert nuance; errors here can significantly skew results, often to the owner's detriment in disputes or sales.

Applying the wrong valuation method (e.g., asset-based for a service business) or standard (e.g., fair market value instead of fair value) can lead to miscalculations, inappropriate discounts, or undefendable conclusions.

This is particularly harmful in legal contexts like divorces or shareholder disputes, where a flawed valuation might be challenged and discredited.

Overreliance on simplistic methods, like basic earnings multiples without adjustments, ignores key drivers and can undervalue growth potential or overvalue short-term gains.

4. Failure to Account for Risks and Dependencies

Inadequate risk assessment, such as ignoring key-person dependencies (e.g., reliance on the owner or a star employee), can devalue the business by highlighting instability to buyers, reducing offers or sale viability.

Overlooking customer concentration risks (e.g., dependency on a few major clients) exposes the business to perceived volatility, leading to lower valuations and deterring potential acquirers.

Neglecting comprehensive risks like market trends, interest rates or economic shifts results in static valuations that don't reflect reality, potentially causing owners to sell at suboptimal times. Additional risks to consider are lawsuits, repuatational risk, licensing risks, accreditation risk, physical risks like flooding, war, etc. lie outside of the organization and can also impact a business negatively.

5. Overreliance on Historical Data vs. Future Projections

Focusing too heavily on past performance without substantiating future growth assumptions (e.g., assuming growth in a news paper printing business) can lead to unsustainable valuations that collapse under scrutiny, delaying sales or eroding trust.

Historical data may not predict future performance, especially in volatile markets, leading to undervaluation if recent downturns are overemphasized or overvaluation if short-term booms are extrapolated.

6. Technical and Calculation Errors

Conflating enterprise value (total business worth) with equity value (owner's share after debts) can misrepresent the owner's true stake, leading to errors in tax planning or sales pricing.

Improper normalizing adjustments (e.g., not accounting for owner perks or non-recurring items) distort earnings, potentially undervaluing the business.

Assuming net income equals net cash flow ignores adjustments like depreciation or capex, leading to inaccurate multiples and values.

Simple math errors or unstable assumptions (e.g., capex vs. depreciation relationships) can catastrophically over- or understate value, damaging credibility in disputes.

7. Wrong Timing or Assumptions About Stability

Using an outdated valuation can misalign with market conditions or events, resulting in values that unfairly benefit one party in disputes or fail to capture peak worth for the owner. Assuming valuations remain static over time ignores market fluctuations, causing conflicts (e.g., family disputes if value rises post-sale).

Delaying valuations until the last minute leaves owners unprepared, with messy documents or unaddressed issues dragging down value.

8. Lack of Professional Expertise and Support

Not using qualified valuators increases the risk of discreditation in court (e.g., Daubert challenges), where non-experts fail to defend methodologies or their lack of reputation discredits their conclusions.

Reports lacking detailed "why" explanations for assumptions (e.g., growth drivers) make conclusions unconvincing, even if accurate, leading to rejected values in legal or sale contexts.

9. Broader Implications Leading to Disputes or Costs

Valuations can exacerbate owner disputes (e.g., non-payment of distributions), where subjective values create perceptions of disadvantage for the benefit of one partner vs. another.

High costs and time investment in valuations may not yield proportional benefits, especially if errors lead to rework or failed transactions.

Inaccurate valuations erode investor confidence, damage reputation, or trigger tax liabilities (e.g., undervaluation in estates leading to penalties).

Neglecting liabilities or invisible costs (e.g., capex, working capital) inflates values unrealistically, setting owners up for negotiation failures.

In summary, while valuations provide a benchmark, their potential for error or bias often means they're not inherently in the owner's best interest without careful oversight, professional input, and realistic adjustments. Owners should consult experts early to mitigate these risks, especially when planning exits or resolving disputes. Also, seek out experts who use software and/or methodology that is only used to valuate similar businesses to yours. Valuation that are backed with a strong guarantee are always preferably over those that aren't. At the end of the day remember that ~80% of businesses that go to market for sale (through a broker or self-listed) never sell. This means that your business is worth what the market will pay for it, not what some analytics say it's worth. If you want help connecting a business owner to a business buyer, BizRetire does it for *free. This article is not to be used for advice, rather for entertainment only. Consult a real professional before making any decisions.