“I Want,” I Need,” and “My Friend Said” Are Not Valuation Methodologies

In my prior post, “Selling a business is a process, not an event,” I commented that most business owner find that their business is worth less than they expected.  This can be a rude awakening when an owner’s mind is set on retirement and the travel agent has been added to speed dial.  Yet the problem persists due to a lack of understanding about valuation and human nature to view the world through lenses built out of anecdotal evidence. After all, the S&P 500 is trading at 16x earnings, so I should be worth 5x-10x, right? Not to mention, my competitor sold for a fortune and we do much more business than they do. 

Truth be told, valuation is much more complex.  The purpose of this article is to discuss why businesses are looked at and valued differently than the public markets, not to attempt to teach you how to value a company, as that could be several semester long courses.  In order for a discussion of the factors that are different between Main Street businesses and Wall Street businesses to hit home, let’s take a step back to our basic finance. 

A business is worth its future stream of earnings discounted to today’s dollars.  However, since it is very difficult to forecast the earnings of a business every year into the future, we often hear investors discussing “multiples.”  We can look at multiples 2 ways:

1)  If an investor is willing to pay $100 for an asset that is earnings $20/year, it is selling for a multiple of 5x;

2) If an investor wants to earn a 20% return on their investment of $100, $20 of earnings is required. 

Thus the relationship is developed that the multiple is the inverse of the rate of return required by a buyer (5 is the inverse of 1/5).  If a buyer requires a higher rate of return on their investment, the multiple is reduced.

The driving force behind Main Street and lower/middle market businesses trading for lower multiples than the public markets is that Main Street and lower/middle market business have significantly more risk, thus investors require a higher rate of return on their money.  In order to increase the multiple and value of one’s business, the risk to future earnings needs to be minimized. 

Let’s explore several areas where lower/middle market businesses are perceived riskier, recognizing that this list may not be all encompassing or apply to every business.       

1) Growth opportunities/scalability: When looking at the public markets, listed companies are selling nationally, if not into global markets. This allows the business to grow with tremendous runway.  Main street businesses are generally regional which may cause constraints due to the size of their market. 

2) Access to capital: As business grows and capacity constraints arise, businesses may need access to capital to expand a warehouse, purchase manufacturing equipment, buy inventory, etc.  Larger entities have easier and cheaper access to capital.  Additionally, the risk to taking on debt is lower for a management team that owns 5% of a company versus an individual with their life savings tied up in their business.

3) Access to talent: Even when growth opportunities arise along with the capital to fund these opportunities, quality team members are needed to execute on these initiatives.  National and International brands with attractive compensation packages and career upside can attract and the best people to help scale the business.  Smaller operations have a much more difficult time accessing and retaining the talent that will enable a business to scale. 

4) Layers of management: The higher the concentration of business conducted by few key employees, the more issues will arise should they leave.  This could include the loss of standard operating procedures and personal relationships that are core to business success.  In larger entities that have multiple layers of management or employees cross trained and groomed for future roles, this risk is minimized relative to their smaller counterparts.    

5) Operating leverage: Operating leverage refers to the amount of incremental revenue that translates into profit.  In companies that have a high amount of fixed cost, the next dollar of revenue is very profitable relative to a company that has a variable cost model.  This is great on the upside, but on the downside it’s terrible when a 10% decline in revenue means a 40% decline in cash flow.  Main street business generally have more operating leverage than larger entities which by itself is not the worst thing.  However, with a smaller balance sheet of cash reserves and working capital, the downside risk of becoming insolvent in the short run is much greater.   

6) Return on additional investments: In the public markets, investors are just looking for a return on their money.  In the lower/middle market, purchasers are looking for a return on both their money and their time. Even private equity groups which may not take active management positions spend time sitting on corporate boards, providing management guidance on strategic direction, and facilitating introductions and meetings with their network.  The return on time drives up the required return on investment. 

7) Not comparing apples to apples: When looking at the P/E ratio of a publicly traded company, the net income number used in the equation is an after tax number.  It is also calculated after paying interest expense on debt, and non-cash expenses such as depreciating and amortization.  Additionally, it does not take into consideration the capitalization of fixed assets that are purchased, which are a real cash expense, but do not show up on the profit and loss statement.  Small businesses are rarely valued by looking at after tax earnings because of the ease of manipulation as the owner may take a salary higher or lower than market rate, overpay or underpay themselves rent on property owned and used by the business, etc.  Generally, the metrics used when looking at owner operated businesses is Seller’s Discretionary Earnings or EBITDA.  Comparing multiples to the broad market is not comparing apples to apples and must be avoided.

The overarching theme is that the more risk associated with a business investment, the less a buyer will be willing to pay.  By removing as much risk to future earnings as possible, sellers will set themselves up to receive a higher price.

Of course, this discussion does not touch upon deal structure.  Is the seller receiving all cash? Is the seller carrying a promissory note? Is the seller required to stay on as an employee for a number of years after the transaction to receive their full compensation? Is the seller only being compensated if the business hits certain financial goals? How much inventory or accounts receivable is included in the transaction? The headline number or sales price may not tell the whole story. 

Don’t fall into the trap of assuming you know what your business is worth.  Speak to a valuation expert.