How to Value a Small Business?

There was a phase of my career when I was on an acquisition trail for small businesses. I had quit my job and decided to get in the steel industry, earlier in the value chain, and attempt a roll-up of the industry.

I figured that the small steel processors were being squeezed out of their margins by the large automotive OEMs out here in South East Michigan. The situation elsewhere in the country was not too dissimilar, just the predators were different. Substitute appliances, or airplanes, or school buses, and you get the same picture.

Typically in scenarios like this when the small suppliers have suffered through a loss of bargaining power over the years, a roll up increases the scale and reclaims some of the supplier power back. Therefore, my brilliant plan was to roll up the industry, and then raise prices. Better margins would pay me back in spades.

As the say, the best-laid plans of mice and men often go awry.

Long story short, within 2 years my acquisitions were back on the market as the great recession took hold.

One of the Key Takeaways for Me was the Insight in the Private Market Valuations of Small Businesses

So I have been investing in the public markets for atleast a decade before I made my private market foray.

And I have to say – the multiples a buyer is willing to pay for a small business in the private market is completely different from what us investors regularly pay in the stock market.

Getting 15 times annual earnings is a dream most small business owners’ dream of when they have an idle minute. Reality is that the lack of liquidity in small business ownership takes a heavy toll on the multiples – as a result you are lucky if you receive 5 times your annual earnings as a bid for your small business. Things get even more complicated as the buyer may want you to stay behind for some time to transition (and the purchase price is negotiated to reflect this). The buyer may also want you to carry a note – again, the purchase price will be amended to reflect this.

There are 2 Methods to Value a Small Business

Small businesses can be valued either as a collection of assets (Asset based valuation) or for their earnings potential (using some Earnings multiple). Let’s take a quick look at these:

1. Asset Based Valuation

This one is very straightforward. If I am buying a business, I can tally up all the tangible assets of the company (buildings, machinery, inventory, computer systems, etc) and figure out the market value (or the replacement cost). Additionally, I may decide that the customer list and other intangibles do have value for me as a new owner of the business, and therefore I will ascribe a value to these assets as well.

I do not care about the management or the operations per se – therefore, the earnings potential of the business does not come into the calculations.

The total asset value gives me a valuation that I am willing to pay.

Now of course, most sellers of profitable companies will balk at this as this method severely undervalues the businesses. However, if the business being sold is defunct, unprofitable, or under duress, this may be the correct method to use. In fact, if the business is family run and a sufficient number of the founding family members/employees are going to depart once the sale is finalized, it is de-facto an asset sale and should be treated as such.

2. Earnings Multiple Valuation

This is more familiar to the stock market investors. However, as stated earlier, the multiples used are very conservative for various reasons:

  1. Unlike a stock, a private small business can not be bought and sold in an instant. This lack of liquidity locks in your investment for a long period of time – therefore the buyers take significant risks and that requires greater rewards in the form of lower purchase price.
  2. Earnings are not publily audited and can come with many questions
  3. A significant part of the earnings may actually depend on the previous owners’ network and relationships that will suffer once he leaves.

There are of course, many other reasons that may make the multiples even lower. I have had discussions at various stages where earnings multiples of 2 or 3 were discussed and this is quite the norm.

Please note that if you are using a business broker than the broker will take a piece of the transactional amount. As a result, the final multiple for the seller will be even less.

A Different Spectrum of Risks Make the Small Business Valuation more of an Art than Science

Every small business that changes hands is valued differently based on the various different situations that may surround the business. The owners’ reasons to sell also carry a large signal that can effectively reprice the transaction at a variance with the typical “comps”. As a small business buyer or seller, you should expect this variability and consider it in your decision making.

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Shailesh Kumar
 

I am an author, investor and entrepreneur. I have published several investment books and founded Value Stock Guide. I have been featured in NY Times, Forbes, CNBC and other places around the web. I grew up in India and attended the Indian Institute of Technology where I studied Electrical Engineering. Later I completed my MBA from University of Michigan Business School. I live in Ann Arbor, Michigan with my beautiful wife and two great children. Our orange tabby cat rounds off our family. I love to read, write, run, hike, backpack, play, travel and help others be awesome.

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