Constraints and Fallacies

Every business, and everyone in general for that matter, faces constraints every day. Some we know and accept, some unknown, and others we fight against. They can be legal, physical (I can’t dunk a basketball), financial, personal, etc. Some are self-imposed, others imposed upon us.

If you own a business, you operate in and around these issues every day. As operator, over time, you become adept at dealing with them or you numb to them. In most cases they can become a real limiting factor of some sort.

Sometimes these constraints can be built on weak footings or worse, completely imaginary. On the personal side, these exist for all of us and I have no right or knowledge to really address these directly. However, on the business side we can see these play out on a regular basis.

When selling a business, these types of constraints can be incredibly costly. An old post on the investment site, Seeking Alpha, got me thinking about this in general (good thing since it was its’ title and purpose). However, something in that article caught my eye in relation to values, deals, hearsay, and misunderstanding data. Quoting…

“This is particularly relevant when it comes to statistics and averages. Consider two groups, each of which contains 10 people. Group A has nine fresh college grads (who each earn $40,000 per year) and one Fortune 500 CEO (who earns $10M/yr). Group B is entirely homogeneous, consisting of ten lawyers, each of whom earns $200,000 per year.

If I can still do arithmetic at two in the morning (which is not guaranteed), the average person in Group A earns one million and change (where change is operationally defined as $36,000). The average person in Group B earns $200,000. Yet it is certainly not true that a randomly picked person from Group A will always earn more than a randomly picked person from Group B – in fact, 90% of the time, a randomly picked person from Group A will earn merely 20% of a randomly picked person from Group B, despite the fact that the supposed average person in Group A earns 5x as much.”

SeekingAlpha

Now apply this to business values, especially when selling. Change income to value (or price) and suddenly new constraint is born. Take any pile of sold business and there will be ranges values. Many owns will say “my “type” of business sells for X times (fill in the blank)”. To be fair, they say this because they were told this. Typically, it is industry peers, friends, well-meaning (but wrong) advisors, etc. Better yet, buddies from the country club – “Did you hear? Tom sold his company for 27x earnings…in gold bullion”. Sure, good for Tom. Heck, even when a public company buys a smaller business, they will have terms in them that can drastically change the actual, received deal over time (good or bad).

This also works if we are looking at comparable transaction data. As they say, the devil is in the details. Any pool of data will have ranges, averages, etc. To make it worse, much worse, each business sale is different, in terms, timing, buyer and seller reasons for the transaction, capital costs, advice, etc. Deal #1 does not equal deal #4, and so on.

So big deal, everyone “knows” this. Well, then why don’t they act like it? Often we (and I mean everyone, I can’t just beat up owners here) either target the high side (by target I mean, they only want the highest number, ever) or ignore the averages issue and therefore ignore the outliers, assuming you could even identify them.

This becomes real issue that effects real people. If an owner is planning to sell for retirement, they need real world numbers, achievable ones. Imagine working out your retirement plan with your assumed business value only find out the real world of buyers thinks you are 30% off. I will tell you this situation is more often the norm than not. Talk about a constraint.

How about the owner insisting on the max of the range, and it is not his real value? There are plenty of brokers and advisors who will throw it out in the market and hope. That’s two constraints now, owner and broker (advisor). Yes, sometimes sellers need “seasoning” and the market is often the best to do that, however is that really efficient for anyone? When trying to sell, a lot of “what ifs” can happen along the way. Hit a bad one of those and everyone loses (look for another post on that very story).

What’s the punchline? We all must proceed, operate, plan, and execute with eyes wide open. Some constraints we can’t control (markets, economy, capital, etc.) but some of our self-imposed (inflicted?) ones we can at least mitigate. Dig up unbiased info, use it, and remove that constraint.

Unsure if you are ready to sell your business?