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Business Risk Characteristics And Their Impact On

Business Risk Characteristics And Their Impact On Valuation Issues

BY: JEFFREY D. JONES, ASA, CBA, FCBI






Introduction:

Acquiring an existing business is one of the more successful methods for getting into business or expanding an exiting business. Public and large private companies have used acquisitions to grow for many years. Based on information provided by business brokers and research by the Small Business Administration, the continued success of people who buy existing businesses is over 75% compared to only 10% to 15% of those who start from scratch. Determining the value of small and midsize businesses is a challenging assignment in light of the fact that very little information regarding actual transactions is publicly available. The lack of available information has led many appraisers to look for alternative sources of guideline transactions and investment criteria from which they can derive applicable valuation ratios and/or investment factors that can be used to convert future benefits into indications of value. Guideline data obtained from public market investments, usually requires substantial adjustments to account for the additional risk characteristics associated with closely held businesses. Because many appraisers lack specific knowledge of the risk characteristics associated with small and midsize businesses, their final opinions of value are often poorly supported and/or erroneously too high. Based on my experience of having been involved in over 1,000 business acquisitions over the past 20 years and my experience as an small business advisor through the SBA's SCORE consulting program, the following information will provide some insight regarding the primary business risk characteristics that impact small and midsize businesses and their effect on valuation issues.

The Market:

As reported in The State of Small Business: A Report of the President 1993,1 there were 19.6 million business tax returns filed in the United States in 1990. Less than 90,000 employ more than 100 workers. The remaining 19.5 million are considered to be small or very small businesses. However, many of these tax returns are filed by either part time businesses or independent contractors such as real estate and insurance agents. The two procedures used by the SBA to classify the number of full time businesses are employment and gross sales. Based on studies conducted by the Small Business Administration, there are 5.1 million businesses with one or more employees. Businesses with under 20 employees account for 89.4% of the total while midsize businesses with over 100 but less than 500 employees account for less than 75,000 of the total. There are less than 15,000 businesses in the U.S. that have 500 or more employees.

Another measure of firm size is annual gross receipts. Approximately 69.3% of all business tax returns report gross sales of less than $50,000 per year. Most of these businesses are considered tobe hobby or part-time businesses. Businesses with gross receipts of at least $50,000 but less than $500,000 account for 76.8% of all businesses. These businesses are be considered to be very small. Those firms with gross receipts of $1 million or more represent only 3.9% of all business tax returns.

Businesses By Ownership Structure:

Corporations represent only 18.6% of all business tax returns filed; however, corporations represent 42% of all businesses grossing at least $50,000. According to the SBA, corporations represent nearly 80% of those full time businesses with employees and account for nearly 90% of the nation's sales and employment. Partnerships represent 11.7% of businesses grossing over $50,000.

Proprietorships represent 73.1% of the total business tax returns, but only 46.3% of full time businesses.

Business Start Ups And Acquisitions:

Each year there are approximately 750,000 new businesses that start up in the U.S.(2) The number of new firms grows by about 15% annually. According to the SBA's studies, annually 2 to 3% of the total businesses in the U.S. survive as successor firms through merger, buyout or similar change. In the January 1995 edition of The Business Broker, 3 a newsletter for the business brokerage industry published by Business Brokerage Press, Tom West reports on several recent studies that estimate the number of businesses sold in the U.S. each year at somewhere between 120,000 to 300,000. According to Mr. West, these numbers are substantially smaller than estimates made by others.

Business Risk Characteristics:

The two primary needs that influence the decision to buy small and midsize businesses are life style considerations and expectations of future benefits. They are so intertwined that it is difficult to separate them from each other. In evaluating businesses to buy that will meet these needs, entrepreneurs look at various business risk characteristics that impact business value. Based on interviews with over 10,000 buyer prospects, the following 10 business risk characteristics are the primary factors that influence the decision to buy and the price to be paid.

Stability of Historical Earnings - The stability of historical earnings and the expectation of their continuance into the near future is one of the mostimportant business risk characteristics considered by most buyers. If earnings are marginal, erratic and/or have a short history, there is a perception of risk regarding the expectation of future earnings. There are three time plateaus which tend to influence the stability of a company's earnings. Those companies with one year or less of historical earnings have the greatest degree of risk as they have not yet established a proven track record of stable earnings. Data from the U.S. Department of Labor 4 Ibid shows that there is an annual 15% growth in new firms. Another 2 or 3% of firms survive as successor firms through merger, buyout, or similar change. This gain of about 17% is typically offset by about 15% of firms which terminate each year. The net gain of about 2% a year is the result, indicating the high risk of new start up businesses. It appears that entrepreneurs tend to underestimate the costs and time to start a new business and reach the point of profitability. The second time plateau seems to occur at about three years. At this point a business has begun to establish a track record sufficient to indicate stability and direction of future earnings. The third time plateau occurs when a company has established a track record of five or more years. At this point, companies have weathered most of the major problems of operating a business and have a high likelihood of continued success. In general, given the same amount of future benefits, businesses with a lon





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