Valuation Gap
The discrepancy between a company's real market value and the price the owner anticipates selling it for in order to meet his or her demands.
What is a Valuation Gap?
A valuation gap is the difference between an asset's market value and its intrinsic or perceived value, indicating potential investment opportunities or risks.
The valuation gap is a particular circumstance in finance. This is when a company wants to sell its business for a price that is different from what a buyer is willing to buy it for. Thus, they are overvaluing and overpricing their business.
On the other hand, the buyer is not willing to buy it overpriced. So this is where the valuation gap gets created.
Some can relate this difference in price to the real estate market for houses. Sometimes homeowners want to sell their houses for personal reasons. Although, at times, their house’s value to them is different from what others think it is worth
Therefore, the homeowner tries to list their house for a price that can be considered fair to them. And a buyer who is interested in purchasing the house may not want it for the listed price.
When the buyer tries to put in an offer, the seller will often reject the offer because they want more than what a buyer is willing to pay.
Let’s take an example and apply it to businesses. A business owner wants to sell their business for a certain price. On the other hand, the buyer may want to buy it for a lower price.
Before putting a business for sale, some sellers may consider getting an appraisal for it. During the appraisal, the appraiser will give the owner an estimated value or price of what the business is worth.
Therefore, it is not always that the business owners want to sell their business for a higher price, but it can just be that they are using the value that was given to them. The valuation gap is also described as the value gap for short.
Key Takeaways
- A valuation gap is the difference between the prices and time a seller and buyer have when selling a business. The ultimate goal for a seller is not to have a value gap.
- Valuation gaps are very common. In today's economy, not having valuation gaps is very rare.
- There are four methods to closing the gap: Issuing a warrant, Stage Closing, Selling part of the business, and Escrow.
- The buyer and seller do not agree on the valuation of the business when there's a gap.
- Sellers should invest in having their company valued to avoid delays.
Why Valuation Gaps Exist
There are a few causes as to why the gap happens. Some may say it can be avoided, while others may consider it hard to avoid. Although, it all depends on the circumstance of why the gap is happening.
The main reasons for a valuation gap are:
1. Time Period
The time period when an asset is sold may be one of the reasons for a valuation gap. The time in which a seller chooses to sell can be crucial. The sale of their company can depend on the market type or the seller's needs.
In real estate, for example, certain time periods may be considered as either buyer's markets or seller's markets. This means that the market during a period can be in favor of either the buyer or the seller.
For instance, if it is a seller's market, then the seller will want to ask for a higher price than what a buyer may want to buy the business for. And when it is a buyer's market, then a buyer may want to ask for a lower price since the market is in their favor.
Note
You may be wondering why a seller would want to sell their business during a buyer's market and risk exposing themselves to the timing issue. Well, simply put, sometimes waiting for the next buyer's market may not be an option.
In other cases, different circumstances happen, markets change, and business owners may need to sell their businesses regardless of which side the market favors.
2. High Expectations
Another cause for the gap would be the seller's expectations. The seller may have emotional reasons for the valuation of their company due to all the "soft" assets they invested.
Some business owners may have sacrificed all their free time and dedicated themselves to building the company. Aside from the time owners have spent, they may have also dedicated money. Therefore all their hard work and emotions toward their company reflect their valuation.
The seller of the company may have expectations for the company due to the hard work and money that were put in, but the buyer's expectations can be different because of the risk they take.
When a buyer succeeds in buying a company, there are things that change within the company, such as:
- Policies
- Practices
- Strategies
3. Different valuation methods
The gap can also happen when the firm's valuation does not match the buyer's. This can happen when the buyer and the seller use different methods to evaluate the company.
Some owners, in particular, do not spend the time and attention to really understand the value of their company.
The valuation of a company can not be found in the company's records or financial statements. Company owners should invest in getting regular and formal business valuations. To have accurate and up-to-date results, they should inquire about them regularly.
Sellers should also educate themselves as much as possible when valuing their company to reduce the chance of reaching the gap.
Bridging the Valuation Gap
When a gap occurs, buyers and sellers will try to bridge or close it.
It is important to close the gap because it can cause up to months of delay in the sale. A delay in the sale of the company can be challenging and stressful for the business owner, especially if they are eager to sell.
Companies can bridge the gap by using the following methods:
1. Issuing a warrant
A way to close the gap would be to issue a warrant. But do not worry, these are not the warrants police hand out to you, but stock warrants.
When closing the gap by issuing a stock warrant, the buyer will agree to the seller's selling amount, with the condition that he/she can buy more shares of the firm but at par value.
During this process, there will be a preset of milestones. If these milestones are not reached, the buyer can choose to exercise the warrant and may be able to increase his shareholding within the company.
2. Stage Closing
The buyer and seller can agree on stage closing. This process will have more than one closing on the company being sold.
When closing the gap with stage closings, the buyer will pay a part of the company's price in advance. The buyer will then finish paying once the business reaches the agreed milestones. However, they can also pay on a set date again if milestones are being reached.
This method can be helpful to the buyer because it can prevent them from overpaying for their purchase.
Note
The milestones need to be agreed upon by both the seller and the buyer.
3. Selling less than one hundred percent of the business
Selling less than 100% means the company will only sell part of the business. You can think of this as sharing, in a way. The buyer and the seller will share ownership of the company.
Due to the seller still being the owner, he/she will still have the right to projects or tasks in the company. The owner can still offer their opinion on how to run parts of the company. They can also be involved in business decisions.
Now let's say the seller was to decide that he does not want to own his part any longer; they can decide to sell their part for cash if they want and need to.
4. Escrow
Escrow is when an agreement is made, and funds get transferred to a third party. Therefore, this method is for when the seller and the buyer come to an agreement on the price of the company. Although going under Escrow typically is due to the fact that there is an agreement pending.
For example, let's say the company has court issues. The buyer may not want to deal with any court appearances. Therefore he will commit to buying the company by giving a third party part of the selling price.
Once the seller has resolved the issues and the firm stands on the financial terms the seller and the buyer agreed on, the buyer will then deposit the rest of the portion that is needed for the sale of the company.
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