By: Patrick Ungashick

Business Valuations & Exit Planning: A Business Owner’s Guide

This is part four of a four-part series on business valuations, written for business owners who need to understand how business valuations are used in the process of preparing for your business exit. As this series deals with tax and legal subject matters, readers are advised to consult their tax and legal advisors. This material is for educational use only. 

How to Select a Business Valuation Professional

There is no such thing as a completely objective business valuation. Every business valuation involves some degree of judgment, which means subjectivity. A human being who values a company has countless decisions and judgment calls he or she must make during the valuation process: which valuation methods to use, what data to include or exclude, how to factor in non-quantifiable issues such as risks, opportunities, market conditions, and more. Even if you are using a software program to do a valuation, subjectivity is introduced by the judgment calls made by the person(s) who programmed the application, and again by the person entering the data. Therefore, if you need a business valuation a critically important question becomes who do you use to do the work?

There is an additional reason to carefully consider who should perform your business valuation. Getting a business valuation is like buying an insurance policy—that valuation may be called up to help protect you against claims against your interests from unfriendly parties, such as a disgruntled business partner, a divorcing spouse’s lawyers, or perhaps even the IRS. Not all business valuations are created equal. The quality of the valuation, and the party who performed it determines how durable that “insurance policy” will be if called upon.

Unfortunately, it’s never been more challenging to determine who you should use to get a business valuation. There are no formal college or university degrees in business valuations, and no state or federal licenses exist. Consequently, many professional advisors will say “Sure, we do business valuations” if asked. An online search turns up countless websites, programs, and calculators that offer low-cost or even free valuations. While free online valuation calculators may be fun to play with, they cannot provide the level of accuracy and assurance that comes with a valuation done by a qualified expert. So, when investigating who to turn to, consider the following:

Professional Experience

While no formal education or licensing requirements exist for business valuations, several organizations offer professional certifications in this field. Look to work with valuation professionals who have at least one of these credentials (listed in alphabetical order):

• Accredited in Business Valuation (ABV). This designation is only to certified public accountants (CPAs) who have passed an exam and have met several thresholds of minimum valuation experience.
• Accredited Senior Appraiser (ASA). To earn the ASA, an applicant must meet specific educational requirements, pass a comprehensive exam, submit their work product to a peer review process, and possess five years of full-time business valuation experience.
• Certified Business Appraiser (CBA). Applicants must meet certain educational requirements, pass a comprehensive exam, and achieve either 10,000 hours of business valuation experience or complete 90 hours of advanced course work. As with the ASA, applicants must also undergo a thorough peer review process.
• Certified Valuation Analyst (CVA). Like the ABV, this credential is only available to CPAs. Applicants must pass a comprehensive exam and complete required course work.

As of the time writing this article, only about 5,000 professionals in the US hold at least one of these credentials. The good news is once you know what to look for, it is not difficult to find them.

How to Find Your Valuation Professional

Should you need a formal business valuation, consider the following steps:

• Ask your existing trusted advisors to refer you to valuation professionals that they know, and hopefully have worked with in prior situations. As a backup method, research online valuation professionals in your area and/or who have experience in your industry.
• Meet or speak with several candidate professionals, share your situation, and ask them how they would approach your needs.
• After initial discussions, ask for a written proposal including a fee schedule and project timeline. Be sure you understand the information and work required of you during the valuation process.
• Once you have selected the valuation professional whom you prefer to work with, have your lawyer review their service contract or agreement. It should contain clear and favorable language about how this professional will respond if called upon to defend their valuation in court, arbitration, or in front of a regulatory agency.

Be sure to review the previous articles in this series (if you have not already) to learn when you might need a valuation, how the valuation process works, and to understand the more common valuation methods. Valuations play an essential role in many business owner’s exit planning process—it pays to know the basics of how they work.

Your Next Steps

Click to register to receive subsequent articles in this series.

If you have a quick question coming out of this article or, if you want to discuss your situation in more detail, we can set up a confidential and complimentary phone consultation at your convenience contact Tim 772-221-4499.

By: Patrick Ungashick

Business Valuations & Exit Planning: A Business Owner’s Guide

This is part three of a four-part series on business valuations, written for business owners who need to understand how business valuations are used in the process of preparing for your business exit. As this series deals with tax and legal subject matters, readers are advised to consult their tax and legal advisors. This material is for educational use only.

Business Valuation Methods

Determining the value of a privately held company is a combination of science and art. Professional appraisers have a toolbox full of valuation methods available to them to calculate the value a company (or in some cases a partial interest in that company.) Applying these methods and doing the math correctly is science. But selecting which method or methods to use is art, because that is determined by the appraiser based on his or her judgement. For you, it is important to know some of the more common methods so you can intelligently discuss them with your valuation professional, because which valuation methods the appraiser uses can produce a dramatically different result. For example, one method might produce a $50 million valuation for a company, while another method might produce a $25 million valuation for the same company—the differences are often that dramatic. So which valuation method, or methods, your professional applies to your company is a critical issue that many business owners overlook or don’t know enough to ask.

There are many valuation methods available to the appraiser, and many methods have several variations. You do not need to be an expert on this topic, but several methods are essential to recognize. They are:

Business Valuation Method #1 – Market Capitalization

Market capitalization, or “market cap,” is arguably the simplest method of business valuation. It is calculated by multiplying the company’s current share price by its total number of shares outstanding at that point in time. For example, if a company’s current share price is $100 per share, and there are one million shares of the company outstanding, then the market cap is $100 million.

Market cap is simple, but it’s typically only applicable to publicly-traded companies because privately held companies don’t have shares traded in the open market. Despite this, it is still important to know what market cap is because part of the valuation process might involve comparing your privately held company to the market cap of publicly traded companies.

Business Valuation Method #2 – Market Value

The market value method attempts to calculate a company valuation based on comparing your company to similar companies in the same industry that have recently been purchased. Market value is perhaps the most subjective method because the professional appraiser must determine and select which companies are comparable despite that in the real world there are no exact matches. Once comparable companies have been identified, then the appraiser must use his or her judgement and apply weighting factors to companies that are dissimilar in characteristics. For example, if your company is doing $25 million in revenue and the valuation professional is looking at data about an industry competitor which recently sold, but this competitor is a $1 billion company, that’s not an apples-to-apples comparison. In that case, the appraiser likely would discount the multiple used on the $1 billion company sale to some lower number applicable to your $25 million company. All of this requires the valuation professional to apply his or her judgement, which is subjective.

All that said, the market value method focuses on understanding what your business might be worth in the open market.

Business Valuation Method #3 – Multiple of Earnings

This method is one of the most important, particularly when considering selling some or all of the company to an outside buyer. Under this method, the company’s recent earnings are applied to a multiplier, which varies with the industry and the economic environment. For example, if the company did $3 million of EBITDA last year and the current multiple for that industry is six, then the potential valuation is $18 million. Typically, the period of time used is the prior calendar year or the trailing twelve months, although if earnings have been volatile over the last few years a weighted average might be used. It is critically important when working with this method that you have accurately calculated your EBITDA, as there are many factors to consider and considerable room for making judgement calls on how certain expenses are treated.

Business Valuation Method #4 – Multiple of Revenue

Under the multiple of revenue method, a stream of revenues (rather than earnings) generated over a certain period of time is applied to a multiplier, which varies with the industry and economic environment. Like with the multiple of earnings method, the period used is commonly the prior calendar year or trailing twelve months, although if revenue has been volatile over the last few years, a weighted average might be used. This method is less commonly used than the multiple of earnings method. It is typically only used in certain industries, such as professional services firms (accounting, legal, engineering, consulting, etc.) and some tech industries.

Business Valuation Method #5 – Discounted Cash Flow (DCF)

DCF is similar to the multiple of earnings method. Using DCF, the valuation professional computes a valuation by taking a projection of the company’s future cash flows, and then discounting them to a single present value—so that cash earned in later years is discounted more heavily than cash earned in more immediate years. The main difference between DCF and the multiple of earnings method is that DCF takes into account inflation and the time value of money when calculating the present value.

Business Valuation Method #6 – Book Value

Book value is simply the value derived by subtracting the total liabilities of a company from its total assets. Book value, therefore, assumes that the company goodwill is zero. Book value is often synonymous with the company’s liquidation value. Book value is typically used in specific situations, such as, companies that have considerable value tied up in their tangible assets. Even when used, book value as a valuation method is not commonly used by itself but rather is often calculated and then included alongside other valuation methods to produce a weighted overall value. (See below.)

This is by no means an exhaustive list of the business valuation methods available to the valuation professional. Also, if you are trying to learn more about these methods take note that different valuation professionals may use different terms to describe the same method, which can be frustrating. However, being familiar with the six listed here provides a foundation from which you can discuss how your valuation professional will select and apply a particular valuation method to your situation.

Business Valuation – A Weighted Approach

Now that we understand there are different valuation methods available to the appraiser, and each method examines different issues and emphasizes different areas, it becomes clear why different business valuations can produce widely varying results even when appraising the same company. To address this, and to create a more balanced and realistic analysis, valuation professionals will commonly calculate a business valuation using multiple methods and then take a weighted average of those methods to produce a final, bottom-line valuation.

While this step reduces some of the disparity between results produced by different methods, it introduces another round of subjectivity into the process as the appraiser has to determine which methods to use, and then how to weight the results. Generally, certain methods tend to earn a greater weighting depending on the nature of the business, the presence or absence of specific data, and the purpose of the valuation. If you hire a valuation professional to appraise your company, it will be vital to discuss which valuation methods are being used and why, and how and why the professional determined the weighted analysis.

Your Next Steps

Click to register to receive subsequent articles in this series.

If you have a quick question coming out of this article or, if you want to discuss your situation in more detail, we can set up a confidential and complimentary phone consultation at your convenience contact Tim 772-221-4499.

By: Patrick Ungashick

Business Valuations & Exit Planning: A Business Owner’s Guide

This is part two of a four-part series on business valuations, written for business owners who need to understand how business valuations are used in the process of preparing for your business exit. As this series deals with tax and legal subject matters, readers are advised to consult their tax and legal advisors. This material is for educational use only.

How to Value a Business

To understand business valuations and how they work, it is helpful to understand the general process most valuation professionals (appraisers) use. The process is more involved and collaborative than many business owners expect. To perform a valuation, appraisers usually do not simply gather financial reports, input numbers into a spreadsheet, and then spit out a figure. You the owner, your company management (especially your CFO and/or controller), and your advisors will work closely with the valuation professional at key steps. The general approach consists of:

Getting a Business Valuation Step 1: Define Your Goals

You and the valuation professional start by discussing the project and defining your objectives and purpose for the valuation. For example, why are you commissioning this valuation? Your purpose will guide the process and, may influence the appraiser’s analysis and conclusions where appropriate. For example, are you seeking the valuation for tax planning purposes? Or are you preparing the valuation pursuant to a pending event such as a marital divorce or business partner buy-out? It is imperative that you and the valuation professional understand your goals. The appraiser’s goal then should be to ultimately, deliver to you a comprehensive and defensible business valuation.

(Note: You may have specific assets such as real estate, equipment, or intellectual property held within your company, or owned in another entity and leased back to your company. Depending on your situation the appraiser may need to review these assets as part of the valuation process, and determine a distinct value for them separate from the company’s value.)

Getting a Business Valuation Step 2: Gather Data

Typically, the valuation professional then provides you and the involved members of your leadership and advisory team with a list of required financial reports and information, usually going back three full years. Commonly the appraiser will want to see income statements and balance sheets, but they may ask for additional detailed financial and tax reports. They likely will also ask for non-financial information such as the company organizational chart, business plan, budget, and any industry data or reports you can provide.

The valuation professional will then study and review the information, using questionnaires and templates they have developed for this purpose. They will subsequently meet with you and the company management to ask additional questions to clarify and deepen their understanding of the company, including its strengths, risks, market, and direction. The better the valuation professional understands the financial and operational aspects of your company, the better prepared they are to achieve your valuation objectives and support their valuation conclusions.

It is critically important that your company’s financial reports and records be current, accurate, and formatted consistent with industry norms and expectations. Otherwise, the valuation exercise could end up becoming a garbage-in-garbage-out exercise. The valuation professional may need to make financial adjustments to account for owner benefits, perks, and non-recurring expenses (commonly called add-backs) as well as understand any intangible assets not fully reflected on the balance sheet. The appraiser must also ask about operational and industry risk factors that can substantiate higher or lower valuations. The valuation professional will also ask for projections of the company’s anticipated future financial performance, commonly called pro-forma financial statements. If you and your management team do not currently prepare projections, the appraiser may assist you in doing so if relevant and advantageous.

As you can see, it’s a collaborative process with a lot of back and forth discussion and exchange of information. This presents the opportunity for you and your management team to give the valuation professional your perspective on the company’s strengths, opportunities, risks, and threats.

Getting a Business Valuation Step 3: Further Research and Analysis

From there, your valuation professional now has plenty of data to analyze from these documents and discussions with you and your leadership team. They may need to recast your historical financial statements, which are often prepared with an eye toward tax minimization and may need to be normalized for business valuation purposes. Additionally, the appraiser may need to research external factors such as economic conditions, industry trends, and comparable transactions within your industry. At each step of the way, if the valuation professional has additional questions, he or she likely will be asking you for further information. In some cases, the valuation professional may need data from your other advisors, such as your accountants.

Getting a Business Valuation Step 4: Preliminary Valuation Findings

While different valuation professionals follow different processes, at this point many will now circle back with you and your team to present preliminary findings. Before issuing a final report, the valuation professional may share their initial thoughts and reasoning, in order to gather your reaction and get additional input from you. What will be significant at this point is not just the preliminary valuation, but just as importantly you need to know how the appraiser got to this preliminary valuation amount. This is the time for you and your team to offer additional input to help the appraiser substantiate a higher or lower valuation, if appropriate.

Getting a Business Valuation Step 5: Final Report

Last, the valuation professional now issues a final report. The reports consist of far more than just the bottom-line number, although understandably that’s what you will initially focus on. Valuation reports should cover an analysis of the company’s risk factors, a detailed description of the company and its market position, and a review and assessment of the prevailing economic conditions and industry trends. Recast financial statements and projections should be included in the report. Then, the valuation professional should clearly state what assessment methods they used to determine their conclusion, and why.

Most appraisers will sit down with you, and relevant members of your management and advisory team, to go through the final report. They should explain all the key points and answer your questions.

Getting a Business Valuation: An Important Tip

There is one important tip to consider if you believe you might need a formal business valuation. Contact your attorney and ask him or her about commissioning the valuation study on your behalf. In other words, you pay your attorney the fee for the valuation and, then your attorney hires the valuation professional for you. The potential advantage this creates is, if done properly, the valuation results will come to your attorney and then may be covered by attorney-client confidentiality. This may be important for protecting your interests. For example, suppose your purpose for getting valuation was tax planning related and you were expecting (or hoping for) a low valuation, but the number came in higher than desired. With the valuation covered by privilege, you and your attorney can safely and confidentially discuss the findings and determine your next steps, including potentially trying another appraiser. Or, the reverse scenario could be true. You could have commissioned the valuation hoping for a high number (perhaps if you are expecting to be bought out by a business partner), but what if the valuation comes in lower than desired? Again, having attorney-client confidentiality may preserve options for you. As with all legal and tax issues, discuss this with your advisors.

Your Next Steps

Click to register to receive subsequent articles in this series.

If you have a quick question coming out of this article or, if you want to discuss your situation in more detail, we can set up a confidential and complimentary phone consultation at your convenience contact Tim 772-221-4499.

By: Patrick Ungashick

Business Valuations & Exit Planning: A Business Owner’s Guide

This is part one of a four-part series on business valuations, written for business owners who need to understand how business valuations are used in the process of preparing for your business exit. As this series deals with tax and legal subject matters, readers are advised to consult their tax and legal advisors. This material is for educational use only.

Why and When Do You Need a Business Valuation?

Business valuations are like police officers—you can go for an extended period without ever needing one, but when you do it sure pays to have a good one on hand. So, why and when does a business owner need to engage a valuation professional to do a formal appraisal of the company? (Note: In some cases, the valuation may also need to appraise specific assets owned by or used by the company, such as real estate, equipment, and intellectual property.) This article summarizes the circumstances why and when a business valuation may be essential and/or prudent. The article then describes the situations when a business valuation may be unnecessary, or even counterproductive and a waste of money.

Subsequent articles in this series will explain how valuations are done, review the most common valuation methods which you need to understand, and discuss who is qualified to do your business valuation should you need one.

Business Valuations: Nine Situations When You May Need One

There are many situations and reasons where getting a formal appraisal of the company’s value is required or exceedingly prudent to do. Listed below are the nine situations where you are most likely to encounter a potential need for a business valuation, especially in your exit planning:

1.Shareholder/Investor Reporting – If you have outside investors/owners, your legal agreements may require you to have an annual valuation for shareholder reporting and meetings.

2.Lender Requirements – In some situations, a bank or other lender may require you to get a business valuation up front or perhaps even regularly such as once per year. (Note: It is more common that a lender will require audited financial statements rather than an appraisal.)

3.Stock Options Plans – If you have a stock options plan for your employees, you may be required to get a third-party valuation each year to comply with 409A regulations.

4.ESOPs – ESOPs (employee stock ownership plans), a tactic to help sell your company to your employees, are required to do an annual valuation to establish the per share value of the company.

5.C-Corp to S-Corp Conversions – If you are converting a C-corporation to an S-corporation, a valuation is required at the time of conversion to determine the potential built-in-capital-gains tax.

6.Gifting Ownership – Another tax-related situation involves gifting company ownership to your children, a charity, or perhaps a trust as part of your estate planning. When making gifts of company ownership, a formal business valuation may not be legally required but usually is highly prudent.

7.Bonusing Ownership to Employees – If you intend to bonus ownership of the company to certain employees, a valuation may be advisable to introduce a third-party estimate of the value of the bonused interest and to help determine the tax impact of the transaction.

8.Co-Owner Transactions or Disputes – In situations involving ownership changes between business partners (co-owners), it may be helpful to secure a third-party valuation to determine the price for any interest to be bought or sold between the co-owners. If the situation has become contentious between the co-owners, perhaps to the point where arbitration or litigation may be considered or involved, a valuation is likely even more beneficial.

9.Marital Divorce – If an owner is contemplating or facing a marital divorce, a business valuation is prudent to aid in the negotiations between the couple, or to be incorporated into any legal proceedings.

There are other reasons that a business valuation may be needed, but this list summarizes some of the more common issues that owners potentially encounter over the course of their career, particularly as you plan for your future business exit.

Business Valuations: Three Situations When You Might Not Need One

There are other situations where a business valuation may come up for consideration. Within our organization, we sometimes see a rush to go get a valuation in some circumstances where the need is less clear. Listed below are three situations where, in our opinion, a valuation may be unnecessary or even counterproductive.

1.You are Getting Ready to Sell the Company – One of the more commonly held views as an owner prepares to sell the company, is that you should pay to have a formal appraisal done prior to sale. Presumably, this is to identify the potential sale price and set realistic expectations. Most of the time, we disagree with this approach as unnecessary and even misleading. First, it is typically unnecessary because if you are working with experienced M&A advisors, they should be able to give you an estimated range they expect the company could sell for in the current environment. This is not the same as a formal appraisal, but usually, it is sufficient to set realistic sale expectations. Second, a formal appraisal before marketing the company can be misleading because what your company is worth to an outside buyer is what that buyer will pay for it. Period. The existence of third-party valuation claiming that your company is worth $X amount will not cause a potential buyer to increase its offer price by $1 more than it is otherwise willing to pay.

2.You are Curious – We frequently speak with business owners who have paid for business valuation at some point in the past simply to help them know what their company was worth at that point in time. It is helpful to have a realistic understanding of your company’s value periodically. However, keep in mind that all valuations ultimately involve somebody’s judgement, and have a subjective element. Paying thousands to tens of thousands of dollars to have a valuation done just to get somebody’s opinion about what the company is worth (even an expert assessment) is often not necessary, because alternative methods are commonly available for no cost. For example, researching sale multiples in your industry (usually tied to EBITDA) can produce an approximate value range for your company based on that data. Clearly, this is not the same depth of analysis nor precision that is provided by a formal appraisal. But a market-based estimate will give you a general understanding of company value on a periodic basis—without the cost of an appraisal.

3.You Want to Track Company Growth – This need is similar to “You are Curious” in that you have no specific event or transaction in mind, but rather you seek the benefit of a realistic understanding of changes in the company value over time. Like with the “curious” example, often paying for a formal appraisal is unnecessary. Rather, carefully research sale multiples for your industry and then apply those multiples to your company performance. In this manner, for little time and no cost, you can approximate company value in most cases, and track its changes over time.

Your Next Steps

Click here to register to receive subsequent articles in this series, where we will examine how valuations are done, the most common valuation methods used, and who is qualified to do business valuations.

If you have a quick question coming out of this article, or, if you want to discuss your situation in more detail, contact Tim  772-221-4499 set up a confidential and complimentary phone consultation  at your convenience.

Stumbling Upon Happiness

By: Daniel Gilbert

Book Review by ReadItFor.me

What will truly make you happy? This summary will give you the answers, but be warned, it may no be what you are expecting!

As human beings we spend a lot of time predicting what will make us happy in the future. For some of us it’s the family vacation we’ve always dreamed of, for others it’s the new car we’ve had our eyes on for years, and others it’s finally paying off the mortgage on their home.

Dan Gilbert makes the argument that we are particularly bad at this task, for three main reasons.

First, our imaginations don’t give us and accurate preview of what our emotional futures will be because our brains fill in and leave out important details about the future.

Second, we naturally project our current feelings into a future that will not necessarily exist.

Third, we forget that things will look differently once they happen in the future.

The antidote, Gilbert suggests, is something that most of us will ignore. Join us for the next 12 minutes as we explore why we are not very good at predicting what will make us happy, and uncover the secret to doing it right.

Why we think about the future: Prospection

Here’s a remarkable fact: human beings are the only creatures on earth that think about the future. This is something that Gilbert calls nexting.

The first type of nexting is a survival mechanism and happens immediately and unconsciously. For instance, if you’ve ever been walking on a trail and heard the sound of a rattlesnake, your first instinct will be to move away from the sound as fast as you possibly can. These instincts are built deep into your caveman brain.

The other type of nexting is more about long range planning, like thinking about where you want to retire, or what you’ll eat for lunch next week at that restaurant you’ve always wanted to go to. This type of nexting occurs in our frontal lobes, and allows us to think about the future before it happens. There are a few reasons we do this:

• It’s pleasurable: by thinking about something you’ll enjoy in the future, you get to experience it twice – first in your imagination, and then in real life.
• To protect ourselves: we anticipate negative events so that we can minimize their impact or eliminate them entirely.
• To exercise control: we have a fundamental desire to control our own destiny, and thinking about and planning our future allows us to fill that need.

Which is all fine and dandy, except for the part that we are not very good at it. Which leads us to make choices that work against our ultimate happiness.

Shortcoming #1 – Realism: Filling In and Leaving Out

The first shortcoming of our imagination in predicting what will make us happy is that we fill in the details inaccurately, and leave out details that are relevant to how happy we’ll actually be.

Filling In

There have been plenty of scientific studies that show that our memories are not reliable representations of what actually happened in the past.

Instead of storing perfect records of past events like, say, a video recording, our brains store snippets of past events in different parts of our brain. And then, when we want to recall a memory, our brain finds those fragments and reconstructs them to build the memory.

Whatever isn’t actually there gets filled in by the imagination. And there’s the rub – sometimes the things that our imagination uses to fill in the gaps didn’t actually happen. And then, the brain restores that memory back with the newly fabricated information. Which is why you can get 100 different versions of an event from 100 different people at that event.

This fabrication, Gilbert points out, happens so quickly and effortlessly that we no idea what’s happening – we just believe that whatever we just pulled up in our minds is an accurate representation of the event.

Now, let’s think about our future predictions. How happy will you be next week if your best friend asks you to go to a party with them?

As your imagination gets to work trying to answer this for you, some interesting things happen. If you are like most people, you start to fill in details about the party – where it will be, who will be there, what food and drink there will be, and you’ll use those details to start making predictions about how happy you’ll be.

The problem is that your imagination went through this entire process of filling in details before you even know what they were, and you start to make choices based on your (probably inaccurate) predictions.

The thing to understand here is that your brain does the exact same thing when you are thinking about more important things in your life, like what job you should take and where you should live.

Leaving Out

Just as we fail to consider how much our imagination fills in when we are thinking about the future, we also fail to consider how much it leaves out.

For instance, when most people are asked how they would feel two years after the sudden death of their eldest child, they suggest that they would be totally devastated, wouldn’t be able to get out of bed in the morning, and would perhaps consider committing suicide.

As Gilbert points out, nobody who gets asked this question ever considers the other things that would happen in those following two years – attending another child’s play, making love with their spouse or reading a book while taking in a spectacular sunset.

This is an extreme example, but it illustrates the point that our imagination almost never captures the entire story.

Shortcoming #2 – Presentism: Projecting the Present onto the Future

This shortcoming is a bit easier to explain. Basically, our imaginations are not as imaginative as we believe them to be.

Basically, we tend to fill in holes in the future with data from the present. We anticipate that whatever is going on right now is what will be going on in the future.

For instance, once you’ve stuffed your belly full at a holiday meal, you have a hard time imagining that you’ll ever be hungry again. We fail to see that our future selves will view the world any differently than we view it now.

Or when scientists are asked to make predictions about the future, they almost always err by predicting that the future will be too much like the present. Respected scientists are on record as saying that human beings would never experience space travel, television sets, microwave ovens, heart transplants and nuclear power.

The tendency to project the present into the future ensures that we have a really hard time imaging a future where we will think, want or feel differently than we do now.

One of the more interesting findings from the entire book is that how we think we’ll feel in the future is determined quite heavily by how we feel right now, even if what’s happening right now has nothing to do with what will happen in the future. For instance, when you are having one of those days where everything seems to go wrong, you’ll be much less likely to predict being happy about the get together you have planned with your friends the following week.

Without realizing it, how you are feeling in the moment has a huge bearing on how you’ll be able to predict your future happiness. And, to top it off, you have no idea that it’s happening.

Shortcoming #3 – Rationalization: Things look differently after they happen

Rationalization is defined as “the act of causing something to be or to seem reasonable.”

We all have a psychological immune system that protects us against all sorts of emotional upsets. Like all of the other mechanisms we’ve been describing up until this point, it operates without us realizing it’s there.

The end result is that we, as Gilbert describes, “cook the facts.” Here’s a quick description of a study Gilbert did in order to explain.

A set of experiment subjects were invited to a fake job interview that they thought was real. In the pre-interview, they were (in the middle of a bunch of other questions) asked how they would feel on a scale from 1-10 if they didn’t get the job. When they didn’t get the job (because that was the whole point of the experiment), they didn’t feel quite as bad as they thought they would. In fact, after a short period of time they were just as happy as when the went in to the interview.

Basically, the finding of all of these studies is that our psychological immune system kicks in to protect us from negative experiences, with three caveats.

First, the negative event needs to reach a certain pain threshold. For instance, it will kick in when you are being rejected at a job interview, but not as much if you stub your toe.

Second, it will only kick in once it’s clear that we can’t change the experience. For example, people experience an increase in happiness when genetic tests show that they don’t have a dangerous genetic defect (as expected) or when the tests reveal that they do have one, but not if the results are inconclusive.

Third, we have a much easier time rationalizing actions that we have taken rather than inaction.

The end result is that we fail to realize our ability to generate a positive view of our current circumstances, and thus forget that we’ll do the same in the future. Ultimately leading us to not accurately predict how happy we’ll be in the future.

The Solution: Asking Others Experiencing It Right Now

As Gilbert points out, most of what we know is not based on our own direct experience, but on second hand knowledge. You’ll find this to be true if you make a list of all the things you know and go line by line marking it firsthand or secondhand.

We believe and put our faith in many things that we have learned secondhand, but when it comes to deciding what will make us happy, we stubbornly rely on our “nexting” mechanism in almost every case. As we’ve already learned, that strategy doesn’t lead to good outcomes. We forget how good or bad things were in the past because of our selective and unstable memories, and then we project those memories into the future to make inaccurate predictions on how we’ll feel then.

This is the point in the summary where we discuss the advice that Gilbert suggests we’ll most likely not take.

By far the most accurate way to determine whether or not a certain future state will make you happy is to ask somebody who is experiencing it right now.

Do you want to know what it will be like to move to a foreign country and leave your family and friends behind? Ask somebody who just did it. Want to find out how you’ll feel about it 10 years from now? Ask somebody who moved 10 years ago.

As Gilbert says, the human race is like a living library of information about what it feels like to do just about anything that can be done. All you need to do is ask.

There are studies that show that when people are forced to use surrogates to determine how happy they will be about a specific imagined future, they make very accurate predictions about their future feelings.

So why do we reject the solution? Because we don’t like to think of ourselves like the average person. Maybe other people are bad at predicting their future happiness, but not me. As you might have guessed, that’s what EVERYBODY says. So while you are busy rejecting the solution because you are unique, you are merely confirming that you are exactly like everybody else.

The biggest mistake we make, Gilbert suggests, is that we don’t make very good predictions about how happy accumulating more “stuff” will make us.

There is a mountain of evidence that beyond a certain level of wealth, it makes little to no difference in the level of happiness you experience. Yet we keep striving for more.

The problem is that the entire market economy system depends on people continually buying and producing more and more stuff. As Gilbert points out, if everyone was content with the amount of stuff they had, the economy would grind to a halt.

So, the next time you find yourself about the pull the trigger on that big splurge purchase, consider finding somebody who did the same and ask them how much happiness it added to their life beyond the initial jolt of excitement.

You might be surprised at the results.

Please share this with a friend/colleague