I’m sitting across the table from a small business owner (let’s call him Dave). Dave’s at the end. His business is failing, or more accurately, the business has already failed.
It was a new food product – an ice cream treat. Carefully created, developed, tested, launched, distributed and sold. They worked hard. Cooked at night, had other jobs during the day, did samplings in stores every weekend, and gained coveted freezer space at stores around the region. Which is to say, they got further than most.
But, at the end of the day, it wasn’t enough. Dave and his wife are done, although they continue to go through the motions. Results didn’t keep up with the drain on their energy and resources – and at this point both are exhausted. In 30 days, they lose their kitchen space, their ability to create product, and all their store freezer space.
And that’s why Dave’s question is perplexing.
“Should I accept the offer?”
Dave has received an offer from a potential buyer.
The buyer offered to pay $5,000 for part of the business including the brand, packaging, product rights, and by extension the current shelf space. The little equipment he has Dave plans to sell online. The buyer has several other compatible products, but had struggled to build the freezer space relationships he needs. The buyer is hoping this small purchase will help jump start his company’s distribution.
But Dave isn’t sure. He’s hesitant. He thinks the offer is dramatically undervalued.
“We paid almost $40,000 for the brand and design work over the last three years!”
Note: The numbers on this deal are small -- and most deals people write about are big. But small deals vastly outnumber big ones.
Before they rolled out the product, Dave and his wife invested a lot of time and money on creative. What should we call the business? What should the logo be? How do we want the brand to appeal to customers? Good questions they knew they were unqualified to answer. They hired consultants. They came up with a brand that is professional and attractive. More importantly, it is a brand that Dave and his wife love.
So, Dave is reluctant to sell something:
- He loves.
- That he invested years of his life building.
- That cost him $40,000.
- That he thinks is worth a lot more.
- To someone who has offered $5,000.
But It’s Disappearing.
I ask Dave a few questions.
- You’re done with the business, right? “Yes.”
- You’re losing your kitchen space in 30 days? “Yes.”
- You’re losing your freezer shelf space soon after that? “Yes.”
- Do you have anyone else who’s approached you about buying? “No.”
- You could use the $5,000 right now? “Absolutely.”
- What happens if you don’t sell it in the next 30 days? “The stuff will probably just end up in boxes in my basement.”
"But I just think it's worth more than that", Dave finishes.
I stop asking questions.
A failed business. Remaining value disappearing rapidly. No other options. What should he do?
Isn’t it obvious?
How can a smart, experienced business owner look at the facts of this situation and not see what is so clear to me (and I’m guessing to you).
Why We Overvalue
I first read about The Endowment Effect about a year ago. The term has been around for decades, and even without knowing the name I’ve been experiencing it my entire professional life.
The Endowment Effect:
“people will value something that they already own more than a similar item they do not own”
As irrational as it seems, the concept is this simple:
- You have an apple.
- You want $1 for your apple.
- I will not buy your apple, because I think it is too expensive.
- I have that apple.
- You offer me $2 for my apple.
- I will not sell my apple because I think it’s worth more than $2.
It makes no logical sense, but as the bigthink.com article titled Rethinking the Endowment Effect: How Ownership Affects Our Valuations, by Sam McNerney discusses, The Endowment Effect states that:
The amount that people are willing to pay for the good is lower than what they are willing to accept when selling it. Put more simply, people place a greater value on things once they have established ownership.
For years as a business buyer, seller and coach I have been confused by other small business owners and their unrealistic perspective on value. Time and time again I would see otherwise pragmatic owners become unreasonable when it came to the value they placed on their business, or assets associated with the business. They would seemingly disconnect from any rational, market-based valuation, and instead base their sense of value on things that would strike me as ridiculous and unrelated – like the value of their retirement home in Florida.
Of course, while viewing this behavior in others as strange, I never questioned whether I was overvaluing my own small businesses(which I was, of course). The Endowment Effect was hard at work. It is:
Our irrational tendency to overvalue something just because we own it.
Early researchers on the Endowment Effect identified the primary cause as fear of loss.
If I sell this thing I won’t have it anymore. And according to researchers that loss “hurts more” than a corresponding acquisition “feels good”. I value avoiding the pain of the loss higher than I value the joy of the gain.
Fear of loss is a common life experience for all of us. And while fear of loss as a motivator would certainly apply to small business owners, more recent studies have questioned the importance of fear of loss in causing The Endowment Effect, and point out that the cause may be more related to how our identity becomes tied to the item being sold. That should be a red flag for small business owners.
Loss aversion has typically accounted for the endowment effect, but an alternative explanation suggests ownership creates an association between the item and the self, and this possession-self link increases the value of the good.
To see if this is true the researchers conducted several experiments, in which they subjected participants to social self-threats. If ownership creates an association between the item and the self, then, as a means to strengthen identity, participants should demand more for items when the self is threatened.
In other words, “after a self-threat… people can use possessions to affirm their self, and endowment effects are likely to be exaggerated.
This more recent research suggests that The Endowment Effect increases based on the bond between self-identity and the “item” being sold.
Can you think of any possession more closely tied to an individual’s sense of self than a small business?
- As a small business owner, my identity is wrapped in, consumed by, and defined by “MY BUSINESS”.
- Then, when I consider the sale of the business, I need to separate from what has defined who I am. A huge self-threat as anyone who has sold a business can tell you.
- And while that is happening . . . I, the owner, have to put a value on that same business.
It’s the perfect recipe for maximizing the impact of The Endowment Effect, and the small business owner is doubly exposed.
The endowment effect is higher for goods that are associated with self.
The endowment effect is higher for goods that sellers have owned for a long time.
For years I have heard business brokers and buyers bemoan the irrational and unrealistic value expectations of business owners.
The Endowment Effect tells us that not only is the behavior to be expected from a seller of any item, but potentially much more so from small business owners that have extraordinary exposure to the influences that cause and increase The Endowment Effect.
What does it mean? McNerney concludes:
The takeaway is obvious enough. We humans are not perfect calculators. Instead, we overvalue our possessions because they contribute to our identity and the identities of the groups we belong to. We don’t overvalue goods because we’re loss averse; we overvalue goods because they are part of who we are.
The goods (the small business) becomes part of who we are.
Back to Dave
"Dave, given the odds of any sale occurring ever, and in this situation in particular, it will be a miracle if you see any money. If you have a buyer interested, run to that deal as fast as you can. Call him right now."
My advice? Take the money. Get what you can while you still can. If you have an asset that is rapidly losing value, an asset that will disappear in a few days, it’s not time to dicker.
That was my advice. It makes “sense”, but then again I have no connection to Dave’s business, while he is just starting to mourn the loss of his business, and his current identity.
The business is part of who he is, and he is deeply tied to the value of that business.
It seems wrong.
To be successful small business owners need to be committed to their business. We wrap who we are with what we do.
But now we learn that our commitment warps our perception of value, sabotaging our ability to successfully sell that business when the time comes.
Lower your commitment – wave goodbye to your ability to build a successful business.
Raise your commitment – destroy your perception of value.
Sigh. What’s an owner to do?
Knowledge Fights Back
So, how do small business owners combat The Endowment Effect?
I’m convinced that we start by understanding that it exists, recognizing what causes it, and calling it out by name. At least for me, the knowledge of the effect and it’s special impact on small business owners has helped immensely.
As a Seller: Since my personal “aha” moment about this topic, I’ve sold two small businesses. Those transactions have gone smoother than any of my past deals, and both occurred with me having a much higher self-awareness about my potential misperception of value.
As a Buyer: As I look at buying opportunities, rather than approaching conversations with owners with a cynical “I hope this one has it figured out” tone to valuation, I start conversations recognizing that The Endowment Effect is likely to have a seat at the table.
I know that the owner will over-value the business. It doesn’t mean I’ll pay more, or suggest someone else pay more when I’m advising, but I now start the process assuming that The Effect is going to be part of the equation.
As a Coach: I talk more openly about The Endowment Effect with owners I’m engaged with. Calling out the effect by name, and talking about the influence on owners. It has certainly allowed for a less emotional introduction of the topic of value gap.
It's too late for Dave, but it's not to late for you to understand the impact The Endowment Effect has on you as a small business owner.
Knowledge of it will better equip you to deal with it and the impact it creates.