Private Business Valuation Trends – Why?

By Maurie Cashman

Private business valuation trends continue to provide information that should be of interest and concern to small and mid-sized business owners. It is generally accepted in the marketplace that larger companies are generally less risky than smaller ones. What implications does this have for your business?

Financial advisors, merger and acquisition professionals, business appraisers, business brokers, investment bankers and many others use the Pratt’s Stats database to determine the value of their subject company by applying the market approach with comparable company data. We constructed the following charts using data from Pratt’s Stats 3^rd Quarter 2017 Private Deal Update.

The Data

The chart above clearly points out two trends:

1. Larger businesses are commanding a higher price in relation to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) over time;
2. Mid and Small-Size businesses are clearly receiving a lower price relative to EBITDA over time.

Comparing the variance between categories we see that:

1. The change between the largest businesses and both the mid and small-sized companies is roughly the same over time;
2. The difference in multiples between mid and small-sized businesses has actually decreased over time.

Smaller businesses command a lower multiple of earnings than larger businesses due to differences in brand power, resources, and relative risk. Larger entities will also command more attention from large acquirers than small companies. After all, if you are going to go through the work and expense of an acquisition, it may as well be one large enough to move the dial for acquirer.

Why are Small Businesses Losing Ground?

The valuations of smaller businesses relative to their earnings have been falling over time relative to the valuation of larger companies. Why? Here are a few factors related to scale that are likely to be increasing in impact over time:

1. Resources. Large businesses have certain inherent advantages over smaller companies. They are usually more established and have greater amounts of funds and resources. Their scale allows them to spread the cost of R&D, capital expenditures and higher cost employees over more volume. Larger companies also have more established customers. Therefore, they can enjoy more repeat business, which produces higher sales and profits. How can you leverage your business position to gain access to the resources you need?

2. Brands. Larger companies typically have strong brands. These brands have become more valuable over time and larger buyers increasingly pay premiums to acquire them for their firms. How can you differentiate your company in the marketplace to create a competitive advantage?

3. Partnership and Collaboration. Larger companies are more likely to have long-term strategic relationships in the form of unique contracts, joint ventures, and vendor and customer relationships that are strategic in nature. How can you better partner with suppliers, customers and other businesses with complementary skills or products to increase your market impact?

4. Customer Retention. As Emmet and Mark Murphy write in their book Leading on the Edge of Chaos, acquiring new customers can cost an organization around five times more than retaining current ones. Reducing customer defection rates by just 5% could increase profitability by 25% to 130%, depending on the industry.

According to the U.S. Chamber of Commerce and the U.S. Small Business Administration:

• The average business in the U.S. loses around 50% of its customer base every five years.
• Companies are four times more likely to do business with an existing customer than a new customer.
• The likelihood of selling to an existing customer is 60-70%, whereas it’s just 5-20% for a new customer.

Do you know what your customer retention rate is? How much business do you do with repeat customers? What do your customers want from you in order to increase their business?

5. Repeatable Sales. Larger entities are also able to design and implement sales processes that can be successfully deployed again and again at ever greater scale. These entities can:

• add new hires at the same productivity level as the entrepreneur or the sales leader;
• increase the sources of customer leads on a consistent basis;
• forecast revenue due to consistent sales and revenue conversion rates;
• acquire new customers at less cost than the amount they can earn from that customer over time;
• deliver the right products in the right place at the right cost at the right time.

This one is all about repeatable processes. What can you do to capture your processes so that they are repeated and systematically improved to create a competitive operating advantage?

6. Leadership. Larger companies may attract more flexible and adaptive leadership. This is partially due to their size and structure. As a company grows it is more likely to move away from the leadership of those that founded and grew the company and toward management better suited to handle the scale of the entity. A problem of small and mid-sized companies is that they often out-grow the specific talents of their leaders and have not recognized the need to make changes that are important to protecting and growing the value of their business.

How honest are you with yourself about the skills and experience needed to lead your organization forward?

Takeaway

In conclusion, each of these areas are critical value drivers that allow large entities to attract both debt and equity capital – driving their values higher. They are likely increasing in importance in private business valuation. You may want to examine these factors in your own company if you desire to increase its value.

© 2017 Aspen Grove Investments, Inc.