How To Attack A Valuation That You Think Is Too Low

We have done hundreds of valuations, and the reasons for getting one are all over the place:

• Estate planning and/or insurance facilitation.
• Splitting a partnership.
• Acquisition or sale with outside party.
• Internal transfer via succession.
• Divorce settlement.
• Merger.
• Curiosity.

Sometimes—though not usually—the process can turn adversarial, in which case we'll move into the "expert testimony" phase. The valuation process is so scientifically grounded that I'm never nervous defending a valuation, but that doesn't mean they are iron-tight exercises. In fact, our preferred method of working is to provide an objective analysis that's initiated by both sides together, concurrently. In other words, we're not working for a given party but for the neutral truth.

But if you do get an honest valuation and you feel strongly that it's too low (as a seller) or too high (as a buyer), there are specific avenues to explore, first. Here I'm going to take the side of "too low" and show you the actionable arguments that will usually be the most substantive:

1. Argue for a higher multiple. This is the most obvious place to start because it's the multiplier. For example, a change from x4 to x5 will increase the valuation by 25%, so it's really significant. But assigning a multiple may be the most expert-laden element of a valuation, and you'd better be prepared to defend it. Just like a new contract can reset the floor for a positional contract in any sport, you'll have to argue that such a comparable is a) normative and that b) you fit the same model. In addition, be sure you understand the context thoroughly. There's more in this episode of 2Bobs, where we talk about just the EBITDA element of valuations.
2. Claim more add-backs. When doing a valuation, the advisor is rightly looking for one-time expenses (or income!) that than can be discounted to make the firm look more valuable. Maybe it's a lawsuit, or an unusual debt write-off, or a move into a facility that required self-funded leasehold improvements. Just a warning: the add-backs I hear people argue for are hilarious and I have to keep a straight face at times.
3. Fight for compensation credits outside of salary. There's some overlap between this point and the previous one, but it deserves its own category. The perspective that feeds this objection is the sense that you are paying yourself way more than it looks because of all the things you are charging to the business: your personal travel, your car, a business retreat that the business helps pay for, a phantom family member on payroll, a big life insurance policy, etc. It's an odd sort of argument because you are essentially giving an IRS agent all the proof they're asking for in an audit, but you really only have a point if your excesses are more excessive than all the other principals in your shoes. It falls a little flat to say that you're a bigger cheater than everyone else, but it also requires a stout belief in your own exceptionalism. But sometimes it is true. Just don't be ridiculous, because you aren't comparing your "comp" with a staff member's comp, but yours against other principals, and most of them are doing the same thing you are. The most ridiculous argument of all is to add back all the executive comp because "the buyer won't need any of us."
4. Ignore a down year. Unlike in valuations from a decade ago, nobody cares what happened at your firm four or five years ago. The focus is almost always on the last three years, and those years are not typically weighted evenly. So, what if your next to last year wasn't great? You can argue that it should be excluded. "Officer, I don't normally speed, but...." And you actually may win this argument, but you'll need some tight explanations. COVID-laced 2020 was an easy one. Your 2021 is going to need a better explanation.
5. Include non-traditional income. There are isolated instances of this all over the industry, but the most recent broadly relevant scenario in this category was the unearned PPP (paycheck protection program) funds that firms received in the USA. While it was widely welcomed as a survival tool, it wasn't actually needed (in most cases). Should that be recognized as income or should it be ignored? In this category you'll also find one-time windfalls from the sale of assets, subleasing income, equity conversion, etc. They are all judgment calls.
6. Keep the rich B/S and just sell the P/L. Our methodology always accounts for anything on a balance sheet, but there are many valuation exercises that pay scant attention to the value of a balance sheet, focusing instead on an income statement. The typical balance sheet accounts for 20-30% of a valuation, though, and so if you haven't received full credit for yours, this is an area where you might concentrate. Or just insist on an asset (vs. stock) sale without any attendant inclusions (mandatory funding of working capital).
7. Focus on terms rather than value. One mantra that you should always keep top of mind is this: "terms are usually more important than price." So say that the price (the valuation) isn't to your liking, but there's very little substantive counters that you can make. Your best bet then is to focus on the terms, instead. Say the valuation comes in at $4M and the proposed terms are one-half in cash at closing and a 4-year earnout that requires hitting a lofty performance target. Maybe your argument accepts the price but angles for better terms, instead.
8. Agree to a taxation exception to favor the buyer. One of the concessions you can make in the purchase is to keep the purchase price at a reasonable level and enter a deferred compensation arrangement in exchange for a non-compete, a focus new business post-sale, or whatever. This can throw you, the seller, into a higher tax bracket (income tax vs. capital gains tax), but it makes those "payments" deductible to the buyer, effectively lowering the buyer's taxable income. This has to be managed carefully and properly to not skirt IRS rules.
9. Claim that it's a strategic purchase. This is the hail mary of objections. "You aren't buying our capacity or our demonstrated income stream, but rather something that will give you an unfair advantage and thus not something that can easily be quantified." In an unfortunate quirk of language, any purchase that isn't quantifiable by normal valuation standards is considered strategic. The challenge, here, is that the buyer is the party who decides what's strategic—not the seller.
10. We're on the edge of exit velocity. This final argument is designed to reverse the stock market axiom: "Past performance does not predict future performance, but in our case the future won't just match the past, but will exceed it!" You'll obviously need to make a powerful argument to support this, but here's an important warning: be ready to see a shift in how the purchase price is allocated, moving away from cash at closing and throwing more potential into the earnout. Never make projections that you aren't willing to stake the overall purchase price on, as a savvy buyer will happily give you enough rope to hang yourself.

So those are the ten most likely avenues to attack a valuation that you think is too low. Even if you aren't in a place where you need a valuation, it's good to understand these things before you do.