Valuation multiples in a sliding economy

If you own a small business or plan to buy one these days you may be wondering – how is the current economic downturn affecting the small business selling prices?

If you are tempted to check the public company stock market for guidance on private business sales – do be careful. The truth is that small business sales are nothing like trading public company stock.

Here are the top 5 reasons for this:

1. Small businesses take a while to sell – 180 days on average

Selling a small business takes quite a bit more time and effort than unloading public company stock.

What this means is that we will see reliable evidence of how the current credit markets turmoil has impacted small business sales months from now.

2. Small business sales are usually closed by experienced business people

Small business buying and selling is a high stakes activity. If your livelihood is at risk, you would approach the business acquisition a bit differently than a part-time stock picker.

To avoid costly mistakes, small business people must understand the business thoroughly before they buy or sell. As a result, successful business people price their deals much better than the typical public company investor.

Before the transaction is closed, there is extensive due diligence. By the time the business sale is concluded, the business buyer has a very good idea of what the business is really worth.

3. Private businesses sell in a private market that moves slower that public capital markets

Usually, the entire business sells, not just a handful of shares as with public company stock sales. An important consequence is that there are a lot fewer small business sales than public company stock trades. So the pricing trends take longer to develop.

Small business selling prices are less volatile than public company stocks because there is little incentive to speculate and take advantage of temporary price movements. The fact is that valuation multiples for private firms tend to change slowly over time.

For example, the valuation multiples for small manufacturing companies over the last 13 years have changed as follows:

Business sale price to gross revenue valuation multiples increased by an average of 1.4% per year. The average multiple was 0.51, being just under 0.6 by the end of 2007.
Business sale price to seller’s discretionary cash flow valuation multiples grew 2.2% annually, averaging 2.22 and approaching 2.45 by 2007 year end.

4. Valuation multiples for private firms depend on the company’s size

Small, privately owned businesses, are generally seen as more risky than their Fortune 500 counterparts. Business people price this additional small company risk right into the valuation multiples.

If you compare the sales of private businesses that are similar in size to yours, you are likely to get a far more accurate estimate of business value than measuring it against a multinational.

5. Small business valuation multiples include company-specific risk

The vast majority of small businesses are operated by their owners. These business people expect additional returns on their investment of time, effort and money in a specific business. The valuation multiples derived from small business sales reflect this type of company-specific risk.

In contrast, public company investors don’t usually work for their portfolio companies and reduce their risk through diversification. Unlike the working small business owners, public company investors do not expect, or receive this additional return.

Is there a better way to value a small business than try to second guess the market? Yes indeed! Remember that the value of any business depends on its earnings prospects and risk.

By analyzing your business from this income producing perspective, you can determine what the business is worth to you – given your expectation of earnings and risk tolerance.

Buying or selling a small business is a big commitment – of your time, resources and talent. It is worth your while to get an accurate business valuation.

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