Last Updated on December 17, 2022 by Anda Malescu
Small businesses comprise the majority of companies (99.7% of all firms) and are employing the most people in the United States.
They are by far the most numerous types of business and see the most merger and acquisition activity. Small business owners might need a valuation for various reasons including purchase or sale of the business, applying for a small business loan, looking to secure venture capital financing, needing a valuation for tax purposes or immigrating to the United States through investment in a business (E-2 visa, EB-5 visa and others).
The US Small Business Administration defines small businesses by the number of employees and the amount of revenue with the most common threshold being $7.5 million in revenue for most industries.
While small revenue and low number of employees are a common factor among small businesses, they exhibit a great variety in the nature of their business, the growth stage they are in and in terms of profitability and financial position.
Small business valuation differs from the valuation for larger businesses in terms of what information about the business is collected and available, the involvement and importance of the owners and the scale and diversification of the business. First, we will examine how small business valuation differs from that of large businesses and later how small business valuation techniques differ within the segment.
The first and most important distinction for a small business valuation as compared to valuing a large business is to determine what role the owners of the business play
How important are they for generating sales, performing the services or manufacturing the goods and how are the business cash flows structured to suite the owners?
First, when a buying a business which employs only the owners it is important to understand if the business can function without them. Can they be replaced? At what cost? Does the buyer offer an employment contact to the owner?
The answers to these questions have to be factored in any projections about future cash flows. Another important factor in valuing small businesses is excess owner compensation and any owner perks. For example, family-owned businesses might be paying excessive salaries for some employees just because they are family members, or a business owner might have purchased a luxury vehicle that is not necessary for the business. In order to estimate what the appropriate cash flows is, excess compensation and perks have to be removed from costs.
Another important consideration for small business valuation is the scale and diversification of the business. Small businesses are hard to compare to publicly traded companies because their market position is less dominant, and their business is less diversified. That creates difficulties when using market multiples or when choosing an appropriate discount rate for discounted cash flow valuation.
The practice in such instances is to apply a small business discount, usually between 20% and 50%, when using market multiples and to add a small company premium when determining the discount rate. The final consideration when valuing small businesses is the lack of data. Often, a small business does not collect the amount of data a large business compile. Here, the important part is to work with the available data and to stick to simpler valuation methods that can be used with limited data.
Small business valuation techniques also differ based on the stage the valued business is in
Some small businesses have existed for many years, have stable cash flows and strong reputation in the community they serve while others are newly formed startups that are still developing their products and marketing strategy. The market multiples method, the discounted cash flow and the capitalization of earnings are all suitable for mature, cash flow generating businesses. For small businesses that do not generate profits but have valuable assets, the asset-based approach is the most suitable.
Startup businesses are by far the most challenging to value because most of them are expected to be cash flow negative in the foreseeable future and some might not even have revenues. In this case, valuation techniques differ from the generally accepted principles and they take into consideration variables such as traction (does the company have customers), total addressable market which shows the potential for growth, the founder’s reputation and history, as well as whether there is a working prototype or any patents or trademarks.
Valuing a small business presents a unique set of challenges. We recommend you retain a certified valuation professional to obtain a realistic estimate of the value of your small business. Contact us or schedule a consultation to help you with your business valuation needs.
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