What is the Endowment Effect?

When it comes to the sale of a business, a common reason a deal falls apart can be attributed to the ‘Endowment Effect’ on business owners, which is where a bias occurs when we overvalue something that we own, regardless of its objective market value (Kahneman et al., 1991).

This effect was proved out when scientists randomly divided participants into buyers and sellers, and gave the sellers coffee mugs as a gift. They then asked the sellers for how much they would sell the mug and asked the buyers for how much they would buy it. Results showed that the sellers (who owned the mugs) placed a significantly higher value on the mugs than the buyers did. They were willing to sell a mug for $7.12 while buyers were willing to pay $2.87.

The principle at play here is that people appreciate things that they already own more than those, which they might own. In this example, the fear of losing the mug (loss aversion) becomes the cause of the contradiction in the evaluation of the cost of the coffee mug.

This also happens frequently to business owners who want to sell their businesses. In fact, 55% of M&A deals fail and over half of that crash because of unrealistic seller expectations. Too many business owners believe their companies are worth more than the buying market is willing to pay (Latest IBBA and M&A Source Market Pulse survey).

As a business owner, the best way to avoid this from happening is to have an objective business valuation performed by a professional, who knows and understands market values and related drivers. This not only can provide a more realistic point of review, it could also assist in helping chart course working towards the desired amount as will help you identify weaknesses in your organization and find ways to maximize the value (BDC, 2019).

Given many business owners have planned their retirement around selling their business, you would be surprised at the number of business owners that have not had a valuation performed. In fact, only 57% of business owners received any kind of valuation on their businesses, and less than 15% of them had a valuation performed in the last two years (The Exit Planning Institute, 2018).

The potential effect of this value disconnect for business owners in Canada could be tremendous when you consider almost three quarters of business owners plan to exit their company by 2028, putting more than $1.5 trillion of assets in play and switch the market from a seller’s market to a buyer’s market (Tracey McVicar, Partner at CAI Capital Partners).

As a business owner, the only real way to avoid falling into the trap of the ‘Endowment Effect’ is to get a reality check by taking action, and having a business valuation performed. It is key to determine or interpret the most probable, or most likely selling price of your business based on the specific market conditions in order to give you a realistic idea of whether to sell and go, or hold and grow as we say. It’s valuable to plan ahead. Remember, the difference between market value and most probable selling price is compulsion.

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