People tend to undervalue things they do not own and overvalue things they own. Among behavioral economists and psychologists, this phenomenon is often called the “endowment effect.” It is well documented in studies and clearly observable in everyday human behavior. Contemplate the following examples:
- How often do you see a house sit on the market because the homeowner’s asking price is well above market?
- You need not look further than silly transactionally focused reality television shows like Shark Tank and Pawn Stars where people often ask outlandish values for their businesses or property.
- In a study, half the people were given a coffee mug at random. The other half received nothing. The group with mugs were asked how much they would be willing to sell the mug for. The group without the mugs were asked how much they would be willing to pay for a mug. The group with the mugs valued the mugs at more than twice what the non-mug group was willing to pay for the mug.
The endowment effect pervades business owners in valuing their businesses as well. I would argue it may even be stronger, as like the homeowner, often times there is an emotional attachment or sentimental value held. In the last few months alone, I have spoken with business owners that support the endowment effect being alive and well:
- a slow growth $4 million – $5 million revenue services business whose owners are insistent the business is worth $80 million (though the owners said they would graciously accept $60 million);
- a small commodity trucking and logistics business feeling that their business will fetch at least 8x earnings while openly acknowledging market multiples for business likes theirs usually range from 4x – 5x earnings; and
- a $50 million revenue distressed business that is losing money and on the verge of bankruptcy whose owner is convincingly (at least to himself) telling everyone that his business is the next billion brand in the space.
The implications of the endowment effect for business owners looking to sell their businesses provides some further interesting considerations:
- Unicorn: Peaks of the business cycle, asset bubbles, and the incessant media focus on start-up valuations, the unicorns of Silicon Valley, and richly priced mega private equity deals only serve to reinforce and magnify the endowment effect. (For more on valuing Unicorns check out our prior posthere.)
- Infrequency of the Event: Most business owners pursuing a sale of their business will only go through a sale process once. Sure you have serial entrepreneurs who may have multiple exits, and you have business owners who get a proverbial second bite at the apple, but these are the exceptions. As a general rule, business owners cannot fallback on a wealth of direct experience and repetitions with the event to perhaps rationalize and question their own biases surrounding their valuation expectations.
- Buyer or Seller or Both?: In private equity transactions, sellers usually are not total sellers. They often “roll-over” equity or retain an ownership piece in the business. Depending on how much is sold, the business owner may be more seller or more buyer. Depending on the dynamics of which owners are selling vs. rolling over and in what percentages, it can add an entirely other layer of complex motivations and topics of interest to behavioral economists.
- Owners are Not Appraisers: Many business owners are not financial savants, ready to articulate the differences between cash and accrual accounting, let alone well versed in valuation techniques. Even if they had put in a few years in investment banking, it likely would not make them immune to the endowment effect.
Not putting a check on how the endowment effect impacts a business owner’s judgment can wholly impede a transaction from occurring and perhaps keep the business owner from achieving his or her desired goals. Business owners can try the following to consciously combat succumbing to the endowment effect.
- The endowment effect is human nature. To combat natural proclivities you must first be aware of its existence. Recognize your bias.
- Attempt to take the emotion out of it. Understand where you have created value and where you have not. Things like cost basis, sweat and tears, and other intangibles (and even some tangible items for that matter) are irrelevant.
- Greg McKeown, author of Essentialism, suggests to try and pretend like you do not own it (whatever it is…your business or some other asset) yet. Put differently, channel your inner Atticus Finch and walk in the other person’s shoes first. View the situation as if you were the buyer rather than the seller. What would you pay?
- Hire knowledgeable and experienced advisors well versed in business valuation and market terms (i.e., an investment banker) to help manage your expectations…and actually listen to them!
While this alone does not insure a stress free transaction (spoiler, one does not exist), it does maximize your efforts to minimizing stresses, bottlenecks, and common friction points in negotiations. Mindfulness coupled with well-reasonedgoal setting can be a powerful tool in selling your business.
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 The term “endowment effect” was coined by University Chicago Behavioral Economics professor Richard Thaler in1980. Thaler has also authored several main stream books including Nudge and more recently Misbehaving.
 This is a well-known and frequently referenced study conducted by Nobel Prize recipient Daniel Kahneman (author of Thinking, Fast and Slow) and Jack Knetsch and Richard Thaler. An interesting point in this study is that the people given mugs did not have a cost basis in the mugs (i.e., they were given to them and thus paid nothing for them). Thus, a common explanation given for the endowment effect is the proclivity for people to focus on their original acquisition cost, failing to view it as a sunk cost. This shows that the endowment effect can exist independent of one having a cost basis in the item in question. Others believe loss aversion plays a significant role.
 A second bite at the apple refers to a business owner selling part of their business (could be a minority or majority of it) but they retain some equity in it and thus participate once the business is sold it total or goes through another liquidity event of some type.