Business Valuation of Small Businesses

In February 2016, the New York Times featured Jack Bonneau, a 10-year-old boy who started not just one lemonade stand, but a chain of them. He obtained funding from Young Americans Bank, which partners with the Young American Center for Financial Education to improve the financial education for kids ages 6 to 21. This year, Bonneau is adding more lemonade stands in Colorado as well as expanding to Michigan through a crowdfunding campaign.

Success stories such as Bonneau’s Jack’s Stands are essential to the spirit of entrepreneurship in America. According to the Small Business Administration (SBA), small businesses provide 55% of the jobs in America. While corporate America has eliminated 4 million jobs since 1990, small businesses have added 8 million new jobs throughout the same period. The strength of the American economy depends on the continual success of small business owners.

While it is clear the importance of small business to the U.S. economy, most of the business valuation methods taught in business schools and MBA programs are difficult to apply to small businesses. Let’s take the market valuation method. Using the market valuation method of business valuation, one calculates the market capitalization by multiplying the company’s stock price by the number of shares outstanding. Once the market capitalization is determined, the business appraiser would adjust it by either applying a discount or adding a premium to the market capitalization assuming the entire company is being sold. While this may be a straightforward approach to valuing publically traded corporations, it cannot be applied to small businesses because small businesses are privately held after all.

Another commonly used approach to valuing businesses is the comparable transactions method. In this business valuation approach, the business valuation advisor looks at similar companies that have been sold in the industry and compare various ratios such as the enterprise value to EBITDA. Unfortunately, comparable sales of small businesses are practically impossible to obtain. Since privately held companies do not have the same SEC disclosure requirements publically traded companies do, most small businesses are sold confidentially without the sale price or financial ratios ever being disclosed.

Finance majors and MBA students will likely study the discounted cash flow (DCF) method of business valuation. There are two main approaches to DCF analysis: the Weighted Average Cost of Capital (WACC) method and the Adjusted Present Value (APV) method. Both of these methods involve building a pro forma of the company’s free cash flow several years into the future, choosing the appropriate discount rate, and calculating the net present value (NPV) of these projected free cash flows. While these are academically beautiful models, applying them to small businesses can sometimes be challenging. After all, building a pro forma of a small business’s projected income and expenses several years into the future can be somewhat arbitrary.

Perhaps the business valuation method used most frequently on small businesses is the multiples method. Using the multiples method of business valuation, various multiples are assessed such as the P/E ratio, earnings multiples, and EBITDA multiples. Even in the multiples method, not all multiples can be applied to small businesses. For instance, the price-to-earnings ratio (P/E ratio) can only be used for publically traded companies. The earnings multiples method is best used for stable and predictable businesses about to make an IPO, and most small businesses are not at the level to make an initial public offering. EBTIDA multiples are used on the higher end of small businesses. What is not taught in most business schools is the owner’s discretionary income (ODI) multiples method, which is more frequently used in the valuation of small businesses.

To promote a culture of thriving small businesses, the business valuation of small businesses should be easier to understand, and hopefully part of the business school curriculum. Currently, our business school and MBA students focus most of their studies on the valuation of large companies, and they end up becoming employees working for finance firms such as Goldman Sachs instead of starting a small business on their own.

It is time for us to encourage more young people to be like Jack Bonneau. At only 10 years old, he is already exposed to bank financing, crowdfunding, and owning a business with multiple locations. Imagine how many more entrepreneurs we will have if our youths learn the basic principles of how to value a small business. It doesn’t have to be complicated, and it does not require a finance degree. What it requires is a basic understanding of how small businesses are valued, and how to get a general idea of how much one’s business is worth using some rules of thumb. Perhaps the business value derived is not as academically accurate as the one calculated using the discounted cash flow analysis, but chances are the buyers of small businesses won’t be using the discounted cash flow analysis to determine the offer price of the business either. An exciting next step for young entrepreneurs like Jack Bonneau is to learn how much their company is worth.

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