How Many Businesses Are There?
We suspect that the answer to this question depends on who you ask! The Internal Revenue Service (IRS) reports that they received some 24.8 million business tax returns for the year 1999. We can hear the joyful sounds emanating from new business brokers and those considering the profession. Wow, almost 25 million businesses! We can hear them adding up the commission dollars. This is a very misleading figure. Many of these tax returns are for hobby-type businesses, one-person consultants, writers, artists and the like. In fact, one source reports that there are 18 million non-employee businesses, and they account for only 2 percent of total sales. INC, in their Small Business issue, reports that Sole Owners generate only 3.3 percent of all revenues and have annual sales of about $38,000.
Home-Based Businesses
According to INC magazine, 61 percent of the firms in their 500 fastest-growing companies list started out as home-based businesses. And, on average, 15 months after they started, they moved to outside space.
We dont want to take anything away from these non-employee businesses, many of which are home-based, as obviously some of them will grow to be large businesses. Quite a few of these businesses, rather than have actual employees, use independent contractors or outsource work needed. Many others are making an excellent living for the owner, and still other owners are quite content with the results of their business. However, they are not the kind of businesses that business brokers and intermediaries normally sell. Certainly, there are a few exceptions — some one-person businesses generate sufficient revenues that would be quite salable. And, it’s not really that business brokers couldn’t sell them or that people wouldn’t buy them. Quite frankly, they are just not commissionable.
Most business brokers, out of necessity, have a minimum fee; adding $10,000 to a selling price of $10,000 would price many small businesses out of the marketplace. There may be a way of handling them, but these small businesses can’t afford full-service brokerage services. This is coupled with the fact that obviously many, many of these non-employee businesses dont generate enough profit, if any, to make them salable. A total annual sales of $38,000 isn’t going to create a lot of excitement among prospective business buyers.
What Is A Real Business?
As we have discussed earlier, we are really only interested in those businesses that have at least one employee. When we are asked how many businesses there are, we assume the person is asking how many possible businesses are available for sale. The above figures give a false impression of the overall marketplace of businesses that might be for sale at some point. Certainly, many of the businesses that have no employees might be available for sale, but most will not. Secondly, business brokers and intermediaries will most likely not be involved in a sale if one does occur. Since most people who call are interested in the business brokerage profession, very few of the businesses that file business income tax returns are really businesses that would sell, especially by business brokers.
Our feeling is that to qualify as a real business, it must have at least one employee. As we mentioned above, we suspect that some no-employee businesses use outsourcing rather than go through all of the red tape required by governmental agencies to have even one employee.
An article in the Boston Globe March 4, 2001 stated that there were 7.7 million small businesses with less than 100 employees. Last year’s Business Reference Guide reported that there were 5.5 million businesses with one employee or more. INC in their Small Business issue said that there were 5.8 million with at least one employee. One other source reported 7.2 million.
BizStats reported that there were 5.547 million businesses with at least one employee. We’re going with that figure.
Here Is A Further Breakdown:
4,467,900 represent 80.5% of the total and have sales under $1 million
790,600 represent 14.3% of the total and have sales of $1-5 million
265,600 represent 4.8% of the total and have sales of $5-100 million
23,311 represent 0.4% of the total and have sales of $100 million +
Total Businesses =5,547,400
*Courtesy: BizStats
Here’s A Breakdown By Type of Business:
Services – 40% (87.8% Of Those Have Revenues Under A Million)
Retail – 19.8% (80.3% Of Those Have Revenues Under A Million)
Wholesale – 7.5% (50.7% Of Those Have Revenues Under A Million)
Manufacturing – 6.0% (61% Of Those Have Revenues Under A Million)
Construction – 12% (81% Of Those Have Revenues Under A Million)
Finance, Insurance & Real Estate – 8.3% (83% Of Those Have Revenues Under A Million)
Transportation/Utilities – 3.9% (81.3% Of Those Have Revenues Under A Million)
Agriculture & Mining – 2.4% (89.8% Of Those Have Revenues Under A Million)
Size Breakdown of Businesses
Here is a common and much-used breakdown by the federal government:
Small Business Administration (SBA):
Very Small Business = 19 or fewer employees
Small Business = 20 to 99 employees
Medium-Size Business = 100 to 499 employees
Large Business = 500+ employees
Checklist for Valuation
1. Start with the business
– Value Drivers: Size, growth rate, management, niche, history
– Value Detractors: Customer concentration
Poor financials
Outdated M&E
Few assets
Lack of agreements with employees, customers, suppliers
Poor exit possibilities
Small market
Potential technology changes
Product or service very price sensitive
2. Financial analysis: Market Value – comparables
Multiple of Earnings – based on rate of return desired
3. Structure and terms: 100% cash at closing could reduce price 20%
4. Second opinion: Even professionals need a sounding board
5. Indications of high value:
– High sustainable cash flow
– Expected industry growth
– Good market share
– Competitive advantage – location/exclusive product line
– Undervalued assets – land/equipment
– Healthy working capital
– Low failure rate in industry
– Modern well-kept plant
6. Indications of low value:
– Poor outlook for industry –
foreign competition
price cutting
regulations
taxes
material costs
– Distressed circumstances
– History of problems – employees, customers, suppliers, litigation
– Heavy debt load
Simplifying the Valuation
“There are many reasons for valuing an entity, and those circumstances can lead to different outcomes…For instance, a business’s value for sale on a going-concern basis will differ from its value for liquidation purposes. It similarly makes a difference if the valuation is for an orderly liquidation as opposed to a forced one. For example, the value of a company for estate-tax purposes (fair market value) likely will differ from its value for a sale to a specific purchaser (investment or strategic value). In some instances involving litigation, the courts or the law may dictate which standard of value to use.”
Source: Journal of Accountancy , August 2003
Introduction
The two variables – EBIT and DCF numbers – are affected by not only the financial aspects of the business but also the non-financial aspects, which can be both objective and subjective. For purposes of buying or selling a company, it is important for the seller to determine the floor price (the lowest acceptable price) and for the buyer to determine the walk-away price (the highest possible offer). Valuing companies may be more of an art than a science, but there are three basic factors that buyers focus on when trying to establish a price for a target company.
1. Quality of Eearnings
i.e., not a lot of “add-backs” or one-time events like the sale of real estate which does not reflect on the true earning power of the company’s operations. It is not unusual for companies to have some non-recurring expenses every year, whether it is a new roof on the plant, a hefty lawsuit, write-down of inventory, etc.
2. Sustainability of Earnings After the Acquisition.
The key question a buyer often asks is whether he is acquiring a company at the apex of its business cycle or whether the earnings will continue to grow at the previous rate.
3. Verification of Information
i.e., the concern for the buyer is whether the information is accurate, timely and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectible receivables? Is the seller above-board, or are there skeletons in the closet?
Measuring Earnings
When a seller talks about earnings, earnings really needs to be defined; e.g., EBIT or EBITDA; last year’s earnings or this year’s projected earnings; EBITDA – CAP X; restated without prerequisites but with add-backs, etc.
When a buyer is analyzing earnings, is it for one year, three years, interim earnings annualized, combination of reporting periods, projections, etc.? What is the timeframe for measuring earnings and what is the trend of earnings?
Another concern in measuring earnings in the future is related to what changes might affect earnings, such as increase in rent, family members off the payroll, loss of key customers and/or vendors, etc. Beware of companies that are locked into long-,term contracts in which they are unable to raise prices or companies in a commodity-type business in which there is unrealistic market pricing.
Key Considerations
The following questions are useful to understand the business and thereby value the company more prudently:
- What’s for sale? What’s not for sale? Does it include real estate? Are some of the machines leased instead of owned?
- What assets are not earning money? Should these assets be sold off?
- What is proprietary? Formulations, patents, software, etc.
- What is their competitive advantage? A certain niche, superior marketing or better manufacturing?
- What is the barrier of entry? Capital, low labor, tight relationships?
- What about employment agreements / non-competes? Has the seller failed to secure these agreements from key employees?
- How does one grow the business? (Maybe it can’t be grown.)
- How much working capital does one need to run the business?
- What is the depth of management and how dependent is the business on the owner/manager?
- How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?
Conclusion
Much of the information above will influence the person’s perception of value. Valuation is often in the eyes of the beholder, whether the price is rational or not.
What Is a Business Worth?
Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.
The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.
So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.
However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.
Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.
Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.