Ask any seasoned business appraiser and you will hear: there are three ways or approaches to measure the value of any business, large or small.
True, but there are some big differences between a small privately owned business and a multi-national giant. To get an accurate small business valuation you need to keep a few key points in mind:
Small business market value comparisons are harder
There is plenty of reliable market evidence to figure out the price of a public company stock or bond. Knowing the price per share and the pool of outstanding shares gives you a pretty good idea of a public company’s market cap.
The pricing multiples are also pretty consistent since public companies are required to follow well-defined financial reporting rules. This being the case, you can generally use a number of pricing multiples to estimate the company value. Examples are price to earnings, price to gross revenue, gross profit, book value of assets and many others.
In contrast, there are no reporting requirements for sales of private company ownership interests. Private businesses may also report their financials differently. Hence, you need to use care when applying pricing multiples.
To make an “apples to apples” business market value comparison, you need to carefully recast the financial statements of a small business. In small business valuation you will see the business revenue, seller’s discretionary cash flow or net cash flow as the common bases for your pricing comparisons.
Availability of reliable transaction data in some industries may be a problem too. In such cases you may need to study business sales in a broader industry group to gain an understanding of how the market place prices similar businesses.
Small business value drivers are different
Values of publicly traded companies are pretty much defined by what the investors think of the company’s financial performance and future prospects.
The value of a small business may be seen quite differently. For many small business owners, lifestyle considerations, such as buying a job or pursuing a lifetime goal are major factors which affect what a small business is worth.
One key reason for this different perception of business value is this: small business owners typically work, and often live, in their businesses. Public company investors generally do not work in the firms they invest in.
The well-known Multiple of Discretionary Earnings business valuation method is a very good fit for valuing owner-operator managed small businesses. The method lets you account for a number of important factors in your business valuation.
Small business ownership interests are less marketable
Small businesses are almost always privately owned. You can bet that private firm ownership interests are considerably harder to sell than their publicly traded counterparts. It takes just seconds these days to unload public company stock.
It may take months or even years to sell a privately owned company. Needless to say, there is uncertainty as to the price you get for a closely held business. Investors view private business ownership interests as higher risk illiquid investments and apply marketability discounts to their value.
Most small business valuations are done on a controlling interest basis
Public company interests are typically valued on a minority ownership basis because most sales are done by investors holding a small number of company shares. On rare occasions when a controlling interest in a public company is being acquired, you will often see a much higher price per share. This is known as the controlling interest premium which can easily range in the 40% – 80% range over the stock’s market price.
When small businesses sell, it is almost always the case that the entire company or its assets change hands. Hence, small business valuation is typically done on a controlling ownership interest basis.
Fair market value standard is typical in small business valuations
There are many more small businesses than large ones. Hence, businesses with comparable earning power compete in the market place, which tends to establish the selling price consistent with the business fair market value.
In contrast, valuation of publicly traded companies is frequently done on the so-called investment standard of value. This is especially true when a company acquisition is planned in order to meet strategic business objectives of the acquiror. Choices may be quite limited here. Business values and, consequently, prices paid for such acquisition targets can reach very lofty levels indeed.
Accuracy of small business valuation requires that you match your earnings basis and cap/discount rates
Income-based business valuation methods require that you estimate the so-called discount and capitalization rates. These rates are determined using a number of cost of capital models. All these models rely on the data you get from the public capital markets.
One very common mistake in small business valuation is applying the discount and capitalization rate to the wrong earnings basis. If you use the famous Discounted Cash Flow method for your business valuation, you can get very good results by building up your discount rate and using the net cash flow as your earnings basis.