by Greg Caruso | Jul 28, 2021 | Exit Planning Business Valuation & Growing Business Value
By Gregory R. Caruso, JD, CPA, CVA
We all know the story: a business has a detailed cash flow projection that seems totally sensible. Then, something happens, and the company does not make those projections. The idea that a company might not make future projections represents a risk in business valuation, and something that as valuators we have to examine. Risk can come from many sources. It can also be quite pervasive in small business valuation. I want to review concentration risk, or where there might be limitations on revenue for a business. Concentration risk can occur in many places, some of which are not always immediately apparent. Here are six concentration risks.
Limited Market Risk
Where is a company selling? Sometimes, the market is only so big. For example, Hilton Hotels have a presence all over the world, which provides them a cushion from any one particular market (say Europe) having difficulty. However, a local franchisee is in one market, and if that market gets overbuilt or has many hotels in competition, it might be harder to find customers or recover.
Limited Product and Service Risk
What is a company offering or selling? A business can have a limitation based on what they sell. During the Covid pandemic, Costco was considered essential because it sold groceries. However, they also sell many other products including clothing and outdoor gear. A small retailer that only sold outdoor gear or clothing was not considered essential and forced to close. Similarly, an accounting firm that had a majority of clients in restaurants would have been more adversely affected by the pandemic than one that had clients in many different industries. Being concentrated in one product or service can be a risk.
Limited Management Risk
Who are the managers? The nature of a small business is that it is small. Most small businesses tend to have a limited number of managers. This means that the loss of any key person can disrupt the business.
Customer Concentration Risk
Who are the customers? Many small businesses can grow quickly by providing services to a few larger companies. However, if their revenue only comes from a small number of clients, then the loss of one of those clients could represent a significant amount of money. Too high customer concentration can be a risk.
Referral Concentrations Risk
Where does the business get new customers? This can be much harder to spot but just as deadly. In one instance, I saw a business with many customers but they all came through one or two referral relationships. If one or both of those relationships stopped referring new clients, where would the business get new clients? Clearly this can increase risk of loss of revenues.
Supplier Concentration Risk
Where does the company get their supply? Anytime a business has only one supplier–particularly if the supplier is hard to replace–that adds risk. For instance, a sole supplier in China that gives good prices is far riskier than many local suppliers.
How should we address these risks in our SBA business valuations, Estate and Gift tax business valuations, and Exit and Succession Planning business valuations?
Market Method
In most instances, companies of a similar size can be searched and selected for comparison. Often these companies will be subject to the same concentrations and limitations. Therefore many of the concentrations I mention above will already have been factored into the multiplier. But you have to take care and examine the sample set. This helps you make sure that if there are outliers and factors that may create a variance, you take them into account and bump your ultimate selected multiplier up or down as appropriate. With experience this process becomes much easier, but in all cases it requires thought and judgment.
Income Method
Data for the income method is primarily derived from public company information. Most public companies are very large (even “small” public companies are usually huge compared to private firms). They might also not have the above concentration risks, and definitely wouldn’t have them to the same degree as a small, one- or two-location business. For this reason, you must adjust for these factors in the Company Specific Risk Adjustment when using build-up methodologies to determine the discount or capitalization rate. Some valuators have tried to create a factor analysis to calculate the Company Specific Risk Factor, but to date on one has been successful. This adjustment contains a lot of professional judgment, where experience is key.
I am Gregory R. Caruso, JD, CPA, CVA, a Partner at Harvest Business Advisors where I have valued and brokered hundreds of small and mid-sized businesses. Learn more about my business valuation services.
by Greg Caruso | Jun 30, 2020 | Technical Business Valuation Topics
Market Approaches in business valuation compare market sales to the company being valued. This is done by estimating a ratio of sales price to cash flow called a multiple or multiplier (i.e. $300 sales price / $100 of cash flow = a multiplier of 3.) Then the selected multiple is applied to the same estimated cash flow of the subject company to determine a value.
Thereafter the multiplier is multiplied against the subject company cash flow to obtain an estimate of value.
Business brokers often have “rules of thumb” that use the market method formula. For instance deli’s sell for 35% of revenues. This is not based on research and detailed thought, just a form of common knowledge. Technically, that does not reach the level of a valuation as it is unlikely to be supportable.
Two primary Market Methods are most frequently used by valuators are:
The Public Company Guideline Comparable Method which uses stock prices from similar public companies. This methodology is really not suitable for most small and very small business valuations as large companies tend to be quite different from small ones. Namely, is Home Depot like your corner hardware store?
The second method is the Private Company Guideline Comparable Method.
The Private Company Guideline Comparable Method uses transaction data from private company sale databases. DealStats, Bizcomps, and Valusource Market Comps are all good sources for small and very small business comparables.
Typically, the valuator will start the process to find comparables by searching for the industry by NAICS (North American Industry Classification System) or SIC (Standard Industrial Classification) system codes. Depending on the number of results (at least 8-10), the valuator may add related codes or narrow the search by company size based on revenues and perhaps profitability based on profits or a defined cash flow. Comparable data is then reviewed using key word sorts, detailed data, charting and graphing results based on cash flow profitability and other indicators to see how similar it is to the subject company. These reviews are very detailed and complex.
Finally, a multiplier is selected by reviewing the comparable data and the subject company for both financial information and soft data. (These resources can include both internal such as concentrations, management strength, systems, etc. and external such as the economy and industry).
This process requires both skill at analyzing the data and professional judgment. But, for small and very small businesses (also known as micro-businesses), the market method is the only method of business valuation that can really be tied into market data.
Typical cash flows used for valuation may include:
- revenues
- gross profit
- EBITDA (earnings before interest, taxes, depreciation, and amortization)
- SDE (seller’s discretionary earnings which is EBITDA plus all the ways one owner makes money from the business)
Each has advantages and disadvantages. The choice should be based on the fact pattern of the business and, of course, the available, selected comparable data. In general, in less experienced valuators hands, EBITDA or SDE tend to result in more useful values than the other possible cash flow choices. This is because people buy businesses based on the amount of money they think they will make in the future owning the business.
In many cases, a final adjustment needs to be made for assets or liabilities on the balance sheet beyond those typically conveyed for the price specified in the market data database.
An example of this is that in many retail businesses inventory purchased by the buyer is added to the value found based on cash flow.
The Market Method for providing an opinion of value of a business is often complex and relies heavily on experienced professional judgment. With a skilled valuator, the Market Method is the best method for valuing most small businesses with revenues below $5,000,000 and should be reviewed carefully for valuing companies with revenues up to $10,000,000 or more.
- Do you need a valuation for your business or for your clients?
- Do you prepare or review business valuations?
- Do you advise business owners based on business valuations as their attorney, accountant, or financial planner?
- Do you ever refer your clients to Certified Valuation Analyst?
Download the e-book “7 Things to Know About Business Valuation“ – and then connect with Greg if you have any questions about a business valuation for you or your clients
Greg is a Partner at Harvest Business Advisors where he has valued and brokered hundreds of small and mid-sized businesses. As Editor-In-Chief of “Around the Valuation World,” a monthly webinar for the National Association of Certified Valuators and Analysts (NACVA), he is in the forefront of current business valuation practices.
