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 long and stable history of earnings will be valued higher than businesses with shorter histories and/or erratic benefits.

Business & Industry Growth Prospects - Research of the history, background and future trends of a subject business and its industry will provide insight into the future prospects for growth in revenue and earnings. Businesses in a growth industry will be more marketable and will sell at higher values than businesses in declining industries, even when they have similar profitability.

Based on the 1993 State Of Small Business: Report Of The President 1993, the fastest growing industries are:

• health and allied service industries
• child care
• businesses services
• amusement & recreation services

The industries showing the greatest job losses are:

• machinery & equipment manufacturing
• building & heavy construction contractors

Stability of Employees - Experienced and skilled employees are an important asset of any business, especially for a new owner who frequently may have little or no experience in managing a business. The costs to find, hire and train employees is expensive and time consuming. A major benefit of buying an existing business is the work force already in place. While sellers of businesses are usually paranoid about their employees finding out that the business is for sale, buyers are equally concerned that employees might leave. Companies with high turnover and unskilled workers create a negative perception with regard to the future of the business and its future outlook of earnings. Companies with low turnover and skilled employees tend to have good track records of business success and will produce market values greater than businesses with short term unskilled employees.

Depth of Management - One of the distinguishing characteristics between small and larger businesses is the depth of management. Larger companies usually have multiple layers of management, which tends to strengthen a company's ability to survive by being able to replace key management without significant costs or loss of business. Small and midsize businesses have few, if any, levels of management below the owner/manager. They therefore have greater risk of earnings loss in the event of illness, death, or poor management decisions of the owner/managers. The more reliant a business is on its owner, the less valuable it is to buyers.

Diversification of Products, Services and Geographic Markets - Another distinguishing characteristic between small and larger businesses is the diversification of products, services and geographic markets. Typically, small businesses have very narrow lines of products and/or services and are restricted to limited geographic markets. Expansion of the lines of products, services and/or markets may be restricted by supplier requirements, customer limitations and/or the owner's inability to raise additional capital required to expand.

Many small businesses are in niche markets that enable an owner to make a good living, but do not provide significant growth potential. As a result, these businesses are not going to be attractive to financial buyers or investors who look for opportunities to take companies public. Larger businesses usually have diversification of products, services and geographic markets, thus insulating them from significant loss of revenue and earnings in the event a specific product line or geographic market is lost or severely hindered. Businesses that are able to diversify are better able to reduce risk and therefore, increase their market value.

Availability of Capital and/or Terms of Sale - The availability of debt and/or equity capital greatly influences the market value of a company . An axiom that is certainly true in business states, "with unlimited resources of time and money, most any problem can be overcome." Many businesses suffer from a lack of both money and time. According to the Small Business Administration, approximately 45% of all new businesses are funded by equity capital because sources of debt capital are severely limited. Public companies can attract equity capital through the sale of stock. The size of a company tends to have a significant impact on the entrepreneur's ability to raise debt and/or equity capital to start, expand or buy a business. While buying an existing business is certainly less risky than starting a new business, raising capital is still a very difficult chore. There is a tendency on the part of financial institutions to view small and midsize business acquisitions with a jaundice eye, given the high failure rate of these businesses in general and the perception that if a business is for sale there must be something wrong with it.

While buyers for larger businesses do have more options available to raise capital, a majority of the reported transactions with values in excess of $1 million are consummated using forms of payment other than all cash. Mergerstat Review 5 reports that only 46% of the announced transactions in 1994 were done for all cash. Another 13% was done for stock and 40% of the transactions were done for a combination of cash and stock. According to Mergerstat, only 28% of the deals valued at $25 million or less were done for cash, whereas 36% of the deals valued over $100 million were done for cash.

Desirability and Marketability For Type of Business - Emulating the mind-set of buyers for small and midsize businesses is a very difficult task. While they are certainly interested in returns on their investments, other characteristics such as life style, pride, nationality and past experience play an important role in determining what buyers are willing to pay. Some businesses are much more desirable than others and tend to sell fast. However, businesses take six months to a year to sell and some never sell despite the fact that they are profitable and the owners are willing to sell on reasonable terms. Characteristics that make one business more or less desirable and/or marketable than others include:

The general acceptance of the business in society - Some businesses can be very profitable, but have limited appeal due to the nature of the business. For example, businesses dealing with adult entertainment generally have a limited acquisition market because entrepreneurs tend to start up new businesses rather than acquire existing ones. While adult entertainment businesses can be highly profitable, they tend to sell at low values due to the low esteem in which they are held by the general public.

The degree of technical or specialized training needed to operate the business - Businesses that require technical training or knowledge are more difficult to sell due to the limited number of buyer prospects that have the perquisite training and/or experience.

The general condition of business equipment and inventory - Equipment in need of repair and/or inventory that is outdated or non-salable will have a negative influence on value.

The size of the business - Often, midsize businesses are easier to sell than small businesses. This is due to the benefit streams being larger, financing resources are more readily available, and the pool of buyers is expanded to include both private and institutional investors who hire professional management to operate the businesses. Businesses with proven track records of low earnings are extremely difficult to sell, except where the assets can be acquired near liquidation value and the business then utilized for another business concept. For instance, restaurants are frequently sold for their tangible asset value and reopened under a new name and menu concept.

Quality of Location and Facilities - The physical appearance of the neighborhood and facilities where a business is located can have an influence on value. Every town has neighborhoods that are considered good and bad. Given a choice, buyer prospects do not want to buy a business located in an area of town considered high risk due to poor appearance, crime and/or poor quality of life. Generally, business located in bad areas of town or have poor appearances will suffer from reduced market values despite other positive aspects.

Competition - Companies in highly competitive industries are often less valuable than businesses with similar characteristics, but in more moderate competitive industries. Unstable markets due to newness of products or services or a poor economy can generate hungry competitors who cut prices in order to survive. As a result, sales volume and profits are reduced for everyone in the industry. Industry characteristics that tend to have a positive influence on value include:

• industries that have a strong trade or professional association
• industries that have stable products, services and pricing
• industries with low company failure rates
• industries that are regulated by government through licensing, permits or zoning which tends to restrict the number of companies

In some industries, competition is very friendly and actually stimulates business for everyone.

Examples include: clusters of restaurants; shopping malls with multiple tenants competing for the consumer dollar, yet jointly advertising to promote business; and auto dealerships jointly advertising and clustering together.

Type of Business - The type of business has an impact on business value due to buyers' perceptions of risk relating to the operational nature of the business and the underlying assets required to operate the business. In general, businesses that are easy to start and require minimal capital investment will be valued less than businesses that require specialized knowledge, licensing and/or heavy capital investment.

Service businesses represent the largest growing category of businesses in the U.S. and now account for approximately 38% of all businesses (excluding finance, insurance and real estate). Service businesses usually require minimal investment in tangible assets and can often be easily started. They have a reputation of going out of business quickly due to heavy reliance on people skills, competition and changes in technology. The value of service businesses will often be less than businesses in other categories with similar profitability but more tangible assets.

Retail businesses account for approximately 21.7 % of all business types. Two major trends in the retail business are franchising and "killer category" stores. Due to the high costs to compete in the retail industry, retailers are joining networks and franchises to gain recognition and obtain purchasing power. Large specialty stores in excess of 10,000 square feet are now competing with products that previously had been in general line stores. The office supply business is a good example. A few years ago office supplies were sold either through department stores or many small office supply stores. Today, many businesses buy their office supplies from large specialty stores such as Office Depot and Office Max. Many of the small office supply stores are now out of business. Small, independent, retail businesses that have to compete with "killer category" stores run a high risk of being put out of business. Small retail businesses are often difficult to sell due to the changes taking place in the marketplace.

Manufacturing account for approximately 6.4% of the total businesses, yet there is a large market of buyers, especially for businesses that manufacture a proprietary product. The interest level in manufacturing businesses is high due to the following:

1. A large number of engineers and corporate managers in the U.S. who tend to be entrepreneurial

2. A substantial amount of tangible assets that can be financed

3. The perception that manufacturing businesses are more stable than other types of businesses and have the potential for significant growth.

In general, buyers and sellers need to be aware of the market of buyers for small and midsize businesses. When there is a large market, the businesses will usually sell quickly and at values significantly higher than those businesses that are difficult to sell and/or the market of buyers is limited.

Buyer Characteristics:

There is no lack of buyer prospects for small and midsize companies. Our brokerage company, Certified Business Brokers, receives approximately 300 inquires every month from people who desire to acquire a business. Some of these inquires are from first and second generation immigrants who have recently moved to the U.S. Because immigrants often have problems with the English language and are unfamiliar with U.S. business methods, they tend to acquire existing businesses rather than start up new businesses. Immigrants will often work for a family member for a year or two and then strike out on their own with the help of family to acquire a business of their own.

White collar buyers; such as corporate executives, bankers, accountants and engineers make up a large segment of buyers for small and midsize businesses. White collar buyers typically want manufacturing or service-related businesses that deal with other businesses. Investment bankers, private investment groups and wealthy individuals are considered to be financial buyers.

Financial buyers are usually looking for businesses that can be taken public within five years. Most small businesses are not likely candidates for going public and many midsize businesses are considered large for the industry that they serve, thus they to are unlikely candidates for being taken public. Financial buyers are interested in acquiring companies with gross sales of over $10 million and are in industries where significant growth is possible.

Competitors and business owners in similar lines of business represent a smaller segment of the buyer market than many people would think. Other than specialty businesses such as bowling centers and automobile dealerships, existing business owners tend to buy only when they can obtain a bargain price. This category of buyer often objects to paying any goodwill value as they believe they already have the skills necessary to obtain business without having to buy someone else's business. While acquisition is a successful means of business growth, many small and midsize business owners are short sighted when it comes to acquiring other similar companies.

Summary

A fundamental principle in valuing small and midsize businesses is that a determination of value is a question of fact that depends upon the circumstances in each case. A proper valuation should include a dispassionate analysis of company specific risks, systematic risks of the market in which a business operates, and the acquisition market wherein that has taken into consideration the size of a business, buyer characteristics and normal terms of sale.

Footnotes

1. The State of Small Business: A Report of the President 1993. United States Printing Office, Washington, D.C.; 1993

2 Adapted by the U.S. Small Business Administration, Office of Advocacy from data provided by the U.S. Department of Labor, Employment and Training Administration based upon state employment security agencies' quarterly reports, 1992

3. The Business Broker. Published by Business Brokerage Press, Concord, Ma.; January 1995

4. Ibid. 2

5. Mergerstat Review 1994. Published by Merrill Lynch Business Advisory Services, Schaumburg, Il.