By Pat Jennings

Most businesses in the US do less than $1,000,000 in sales and they are owner-operated. Yet our media write almost exclusively about much bigger businesses — even in sections of their web site or paper that are labeled “Small Business”.

On today’s New York Times Small Business Blog — entitled “You’re The Boss” — the lead stories are about the future of Silicon Valley and Ford Motor Company’s plans to add 850 jobs to their Dearborn Michigan plant. And the lead story on Huffington Post’s small business section is a puff piece about Sir Richard Branson.

And when it comes to the vital topics of selling and valuing the majority of America’s small businesses, the media does the same thing. They label their coverage “Small Business” and then proceed to discuss very big companies.

Sure, the companies they cover are Smaller-Than-Exxon but they have little in common with the majority of American small businesses.

Their coverage does not convey the reality in which most small business owner’s operate.

Truly small businesses are owner-operated. They serve a limited geographical area. They don’t have a board of directors or a “management team”. They do less than $1,000,000 in sales and except for some restaurants that have lots of part-timers they employ fewer (usually way fewer) than 20 people. For the sake of clarity I’ll will refer to these businesses as The 1–20’s going forward (under $ 1 million in sales and under 20 employees).

We can go into endless detail about Census Bureau data or the definitions of “small” used by the Small Business Administration. But the fact is this: More than 90% of American businesses fit into the 1–20 classification but the other 10% get all the media coverage.

This fact is the single greatest source of confusion, frustration and disappointment among business owners once it comes time to sell

And especially once it comes to value their businesses.

For too many owners of 1–20 businesses their expectations about value are set by all wrong information sources. What may be true for a tech company being bought by Google or an inventor pitching the sharks on Shark Tank is not true for most businesses.

I wrote last week about the real-world factors that determine valuation multiples for The 1–20’s. This week I want to talk about how bigger companies are valued so you understand where the different valuations for different sized companies come from. I can assure, despite how it may seem, they don’t just fall from the sky.

Specifically we need to understand the differences in the types of buyers if we are to understand the differences in the types of valuations that a company may get.

Different Types Of Buyers For Different Types Of Businesses

Professional Investors — These are venture capitalists and private equity groups. They may have an intermediary approach them with an investment opportunity that is currently on the market. But mostly they proactively seek out companies in specific industries that they know well.

They target companies that they believe have good management in place and that have the potential for fast growth.

Since they are experienced in buying similar companies they already have a formula to value/price a business.

They know what they are looking for. They know what they can afford to pay based on real world experience. And they know specifically how they plan to grow the business by adding their capital, marketing know-how and/or management experience.

Industry Buyers/Larger Competitors — While the professional investor will probably be interested in a few different industries, the Industry-Buyer is looking specifically for companies exactly like, or complementary to, the one they already own.

Unlike the professional investor, the industry-buyer doesn’t care that much about the upper management of the company they are buying. They already have their management team in place.

Buying up similar companies in other regions can allow a company to quickly expand geographically.

The other big benefit for the Industry-Buyer is usually economies of scale. In a sense they are buying new customers. By acquiring many new customers a business can ramp up production, buy raw materials in larger quantities and thereby lower per-unit costs.

They can also lower overhead further by eliminating redundancies that exist. For example, they likely will eliminate or shrink the managerial staff of their new company because they already have their managers in place.

All this means the same number of customers buying the same amount of product can lead to better profits.

Strategic Buyers — This is the category of buyer that gets the most attention from big media.

Strategic buyers are looking to acquire assets that only the target company can offer — specific technologies, patents or other proprietary content. Things the acquiring company can’t easily go out and create for themselves.

Google makes news all the time buying up smaller, often unknown, companies for millions or billions of dollars. The money they paid for YouTube was based on what YouTube could do once it was part of the Google family, not on the profits it had already produced.

Google didn’t just want to be a search engine. They wanted a complete array of services that would make them a one-stop destination for anyone with an Internet connection: Gmail, Google Docs, Google Maps etc. Video sharing was obviously a big part of that plan — but their platform wasn’t doing too good. So instead of building their video operation organically they just used their cash to buy the most attractive property in the space. Strategic mission accomplished.

These are rare but newsworthy deals. Unfortunately they tend to fuel the expectations (and dreams) of business owners who offer no strategic value to a strategic buyer.

Why High Valuation Multiples Are Justified

motivation effects small business valuation multiples

One thing all three buyer-types have in common is that they are looking for very specific types of businesses that meet a very specific set of criteria. They will look at dozens, if not hundreds, of candidates in order to make just one acquisition. We never hear about the deals they walk away from. In fact we don’t hear about most of the ones they do make — just the really expensive ones. Just the one’s with a WOW-Factor.

Recently, Facebook purchased WhatsAPP for $19 billion. For several weeks it was the most talked-about business story. One month later they bought something called Oculus VR for a measly $2 billion. I didn’t know anything about this deal until I started doing research for this blog post.

Patented products, proprietary software, economies of scale, experienced management teams and operating systems already in place. The potential to quickly and dramatically increase margins and market share.

As often as not, the acquiring company is more motivated to buy then the target is to sell.

These are the things that justify a multiple in the 4–8 range.

Small Business Buyers Operate The Business Like The Seller Did

Contrast all this to the typical 1–20 business that is for sale:

• Rarely are there patents or proprietary information involved.
• The new owner is the management team.
• If the buyer is a first-timer they won’t have any geographic expansion or economies of scale to exploit
• The individual buyer usually finds businesses that are already advertised for sale. They don’t approach an owner unsolicited and try to motivate that owner to sell. The seller is usually more motivated than the buyer.

But the defining feature in most cases is that they are owner-operated. The owner is the chief cook and bottle washer. “A Job That You Own” is the way I like to describe the majority of these businesses.

These 1–20 businesses are owned by an individual entrepreneur and will be bought by an individual entrepreneur.

That’s why we say your business must be valued based on proven profits: The business will be operated in much the same way it always has been operated after it is sold.

A new, less experienced owner will do well in the first year to maintain sales, never mind drastically increase them.

There likely are not going to be any economies of scale to exploit once the new owner takes over. There are no redundant resources/expenses like management teams that can be eliminated. There will not be a higher infusion of cash from a big investor.

And it is rarely the case that the owner of a local gift store, sandwich shop or landscaping business is pursued by a bigger operator that wants to buy the smaller business as part of their aggressive expansion plans. Large companies that deal in these local service and retail type businesses almost always expand through franchising. They have no interest in buying out local, owner-operated competitors.

Conclusion: Earlier I said that the misunderstanding about why different sized companies are valued on different scales was the single biggest source of frustration and misunderstanding among entrepreneurs who want to sell. I mean it.

Every survey on the topic that I am aware of shows that the number one reason small businesses fail to sell is “unrealistic price expectations” on the part of the seller. And the number one thing creating these “unreasonable” expectations is the fact that the smallest businesses — The 1–20’s — don’t get any coverage in the media. The people who write about small business are “generalists”. They are not sophisticated enough to know that there are real differences between a small business with $100,000 in sales and one with $10,000,000 in sales. The distinctions I have laid out in this post are completely unknown to most journalists who write about small business.

Like I said they are generalists. They write about business in general. Even when they say they are talking about ‘small business” our media is usually talking about multi-million dollars companies, the smaller-than-Exxon businesses .

The bottom line is that The 1–20’s is a unique category of small business. It is valued in a way that is unique from bigger businesses. And the media, even the business media, doesn’t understand this. When it comes to determining the value of your business most of what you hear in the media won’t apply to you — the writers are almost always talking about businesses that are anything but small.

For a step by step guide to setting the asking price for your business you can download our free 27 page Business Valuation Guide by clicking here