Valuing small business using financial statement evaluation and ratio analysis (quantitative analysis) can be difficult because companies do not tend to follow industry or GAAP standards. Even when cash flows are correct, other financial information may not compare well with available data. This means the business valuator must put more emphasis on understanding how the business really works beyond the numbers (qualitative analysis). This way, the valuator can determine if the business has resilience. Resilience allows the company to survive and thrive when roadblocks appear. This means that the business is more likely to meet financial forecasts, reducing risk. Here are a few soft factors that business valuators can review as part of proper qualitative analysis when quantitative analysis is not available.
What are the components to business valuation?
There are two main components to valuing a business. The first is forecasting future cash flow. Then, we determine the risks and likelihood that the risks will reduce the expected cash flow. We address risk using the discount or capitalization rate or the multiplier. The two components, cash flow and risk, are somewhat inseparable. For example, if we forecast a very high cash flow for a company, the risk of meeting the cash flow automatically goes up to some degree. In every business valuation the factors that should be reviewed and the impact on risk to the company can vary.
What are the qualitative or soft factors to review in business valuation?
What are the cash flow trends over time?
High margins and growth usually portend more good things.
What is the management structure and the size of the company?
Owner/operators who do everything create risk. If something happens to them, the business might be in a lot of trouble. Furthermore, most buyers do not want to stock shelves if the stock person does not show up.
What are the concentrations?
As I have said many times, concentrations kill. Yet small businesses are always going to have some. Concentrations can include geography (New York City was a much worse place to have a sit down restaurant in 2020 than most of Texas), management, suppliers, referrers, keywords (many an internet company lost profitability when keywords got too expensive), suppliers, referrers, customers, etc. For a small business, each of these create more risk than with larger companies in the same industry. They might even be way beyond what the typical small company comparable might have. For instance, we would have to adjust for more risk when comparing a commercial landscaper with only a few large clients to the typical landscaper with large number of smaller clients.
How well is the company organized?
Organized companies with standardized processes that work every time are much stronger and deserve high business valuations than when a few people make all decisions shooting from the hip. Remember what my dad said: “Great systems exist when average people get extraordinary results every time.”
What is the workforce and employee base like?
Traditionally, many industries have placed an emphasis on management. However, having a loyal, well-trained workforce increasingly brings strong value. In a technical world, ramp-up time and training costs can be significant. This can be reduced if a qualified workforce is in place.
What is the company culture like?
Company culture can be very hard to assess. But some companies have a culture of overcoming problems and obstacles, which can be an asset. This is an important asset. A motivated can-do company culture greatly reduces risk. But be aware, it can change as management changes.
Most of these quantitative factors in business valuation are hard to assess and translate into numerical risk assessments. (Eventually we do have to work it into our quantitative analysis.) Unfortunately, much of it will never get beyond the claim of professional judgement. In fact, it is why professional judgement is more important in small business valuation than many other accounting and finance functions. Sometimes it is easy to see the advantage, but hard to assess an exact increase or decrease due to the complex interplay of factors. For instance, problems that might be a small bump in a fast growing economy could be the kiss of death in a recession.
This is why I say that business valuation is an art and a science. If you have questions about business valuation for SBA loans or planning and exit or succession, estate and gift tax, or ESOP’s contact me today.
Gregory R. Caruso, Partner, Harvest Business, LLC t/a The Art of Business Valuation.