Have you ever heard of it? Well, if you are thinking of selling your business in the next few years, it is a term that you should get familiar with.

Sadly, it is one of the bigger reasons why deals go awry in the lower-to-mid market tier. And, it can be avoided.

There are a variety of reasons why a seller may think that their business is worth more than what others are willing to pay for it.

Some business owners simply need the business to sell for a certain amount in order for them to retire and maintain their lifestyle. They have spent their life building the business and have an expectation that the business will take care of them in retirement.

In this case, the business owner has been told that another company in their industry sold for a certain multiple of revenue, thus implying that their business has a certain value.

The problem is that you do not know the circumstances of the transaction.

Were the terms favorable or unfavorable to the seller? Are the two businesses truly comparable in size, capital structure, management depth and competitive position? Was it a buyer’s or seller’s market at the time of the transaction? Was the company a particularly good fit for that particular buyer? You get the idea.

Unless you know the details of the business and transaction (highly unlikely if the company is private), there are just too many variables that could make the transaction (and implied valuation) irrelevant for your company.

Some business owners believe that their company should be worth their capital investment plus a reasonable return. Seems rational. Let’s say a company invested $1 million in R&D and manufacturing to produce a product. The owner logically thinks they should be able to get a reasonable return on their investment given the risk – say $1.5 million. Right?

No. A buyer doesn’t care how much you spent. Your investment is your sunk cost. A buyer only cares about how much they will make for the investment (and risk) they are about to make. When they purchase a business, that will be their sunk cost and it will be up to them to make a return on that investment.

If the buyer and seller cannot agree on price, then negotiated terms can help bridge the valuation gap. These include:

An earn-out is additional money paid to the seller when certain revenue or earning criteria are met. In many cases the buyer will only pay a portion of the asking price up-front with additional payments if (and when) the business lives up to expectations.

The seller can also provide a note to the buyer with a high interest rate. That way, they earn more over time in the form of interest in exchange for a lower price and providing a portion of the financing.

The best way to close the valuation gap is to avoid it all together. This is done by having a valuation of the business completed well before the sale.

In fact, most experts recommend having a business valued every other year (annually for larger businesses) in order for owners to track and maximize the business’ value.

A thoughtful valuation will give the owner a deep understanding of the company’s value. And, if completed early enough, there is time to increase the business’ value by implementing value enhancement strategies before the sale.

Not only will the ultimate value better meet the owner’s financial needs and expectations, but it could also lead to more interested buyers and cash (more favorable terms) upon closing.