Here are two simple truths:
These two simple truths combine to create a remarkably dangerous situation for small business owners.
Because most lessons of big business mergers and acquisitions do not apply to small businesses. In fact, the small business truth is often the exact opposite of the big business reality. If you don’t understand that, big business M&A stories will really screw up your understanding of what it means to create a small business you can sell someday.
Let’s Define Terms
For purposes of this article, we’re going to call any business under $5 million in revenue “small”, and any business over that size “big”. This article is only for “small” business owners (so only 96% of owners should keep reading).
Make no mistake, the authorities disagree with this simple definition.
The Small Business Administration sets small business criteria based on industry, ownership structure, revenue and number of employees (which in some circumstances may be as high as 1500, although the cap is typically 500). Wikipedia
There’s surely a rational for calling a business with 500 employees small. After all, 500 is small compared to 5,000,000, but these comparisons seem meaningless to businesses that are actually small.
So we’re agreed, you own a “small” business.
Now, what makes big business M&A information so dangerous to you? Let’s take a look at three examples of how innocent, and often accurate, big business M&A information can warp your small business truth.
#1. You Read: “The company was valued at 10x earnings, which is below the national average.”
How it hurts you:
Most small businesses are sold with a value calculation that takes seller’s discretionary earnings (look here if you don’t understand this term) times a multiple. The average national small business multiple is around 2.5. So, to drastically oversimplify small business valuation, let’s say that the average small business is valued with this calculation: 2.5 x SDE = value.
In contrast, non-small businesses are usually sold through a value calculation of EBIDTA times a multiple. EBIDTA is different than SDE. And while the multiple varies by business category, EBIDTA calculations almost always have a much larger multiple. For example, this data shows an almost 11x multiple average for certain mid-market companies. So oversimplifying once again, non-small businesses in this category are valued with this calculation: 11 x EBIDA = value.
You read . . .
The firm was valued at 10x earnings, which is below the national average.
The Small Business Truth is: Your multiple will be MUCH lower.
When you see high multiple valuations as you read about M&A deals you think “I should be able to get that kind of multiple when I sell my small business.” Let’s be clear: you will not. If you are doing multiple math on your own, 2-2.5 is where you should be starting. (A business valuation, or value assessment from a broker, might show that you should change that number up or down.)
It’s a simple error to make when we see multiples of 8, 10, etc. That will not be your multiple. These figures will tragically impact your perception of value, and hurt your ability to ever sell your small business.
#2. You Read: “Although the business hasn’t been profitable for years, the purchase price was higher than most recent deals”
How it hurts you:
Big businesses are acquired for a wide variety of reasons. Some of them can seem. . . well, “fuzzy”.
Take something like “location” for example. If “business A” owns three manufacturing plants located around the country, that might mean something strategically special to “business B”. It might be so special that business B pays a premium for business A. Perhaps business B knows that the acquisition cuts 3 years, and 50% of costs off their current national expansion plans. So, the deal, even at a premium price, might make good business sense – even if business A is unprofitable.
Location, brand identity, distribution networks . . . all sorts of more intangible, “fuzzy”, strategic elements can create value in a big business. Those elements might legitimately play a huge part in why one big business is purchased by another big business.
Small business owners are understandably attracted to the fuzzy value complexities of the big business world. We want to believe the value in our small business is created by something mysterious. Some unique decision we made in the past. Something we might personally treasure. Maybe we really love our brand, after all we spent tens of thousands of dollars with a consultant creating it.
Everyone loves the brand.
Doesn’t that brand make our business valuable?
Small Business Truth: Nothing “fuzzy” will overcomes the importance of meeting your buyer’s basic financial needs.
While there are multiple elements that can create value in a small business, they all pale in comparison to your basic financial results. If your small business doesn’t produce financial results that allow your buyer to earn a living and make payments on the debt they incur to buy your business, it’s unlikely you will ever sell your business. That is a simple, sell a small business truth that can be really hard for us to accept. (If you don’t believe it, try arguing with the logic here).
Are there exceptions to this? Sure. But do you want to try to build your successful exit around being the long-shot exception? Complicated, big business value elements don’t change the simple truth that for small business owners: “my results buy my business.”
#3. You Read: “We saw a 3x impact on value when our revenue rose to $200,000,000”.
How it hurts you:
Some big businesses sell at spectacular, multi-billion-dollar valuations before they ever show a penny of profit. They grow revenue to nose-bleed levels while eating through enormous amounts of capital, as they race to their public offering or private equity acquisition. When they sell, and the 26-year-old founder becomes the latest billionaire, press coverage overwhelms every outlet.
And we as small business owners conclude: revenue is good. It must represent great value to a potential buyer.
Small Business Truth: Revenue is easy. Profit is hard. Small business buyers buy profit.
Small businesses almost never sell because of their revenue, yet so many of us have read and believe that our business value is based on some multiple of revenue. Let go of that unicorn inspired myth. Revenue has value for your small business, but only because it contributes to this equation:
revenue – expense = profit
If your revenue doesn’t contribute to a profitable result, it would be a huge mistake to assume you’re creating value by growing your top line. Yet we read about the latest “unicorn” business sale and revenue is all they have to offer. It’s so easy for us to chase the latest unicorn story and think it applies to our small business.
Our Path is Hard and Made Harder by Big Business Stories
Creating a business you can sell is simple, but not easy. To do it right, it’s critical that you understand and focus on the simple elements that make a small business attractive to a buyer.
The sad truth is that most “sell a business” content is focused on big business stories. Unfortunately, that content does more harm than good for true small business owners. The three examples we’ve used above could have been any of 300 others. So much of what happens in the M&A space doesn’t apply to us. Our businesses are different.
They are small.
We will never play the “sell the business” game like they do. The rules are different. The incentives are different. It is not the same game.
Say that out loud: It’s not the same game.
Stop thinking it is.
A successful sale of your small business can be in your future, but only if you read that big business content with great discernment, or better yet, stop reading it entirely.