Before You Buy — Recognizing Small Business Value Drivers
Small Business Value Goes Beyond the Financials
When it comes to determining small business value, one of the most common question buyers ask is, ‘If I buy this business, how much money can I make?’ Yet, it’s important to look beyond the financial records when determining small business value. Oftentimes, financial records can be inaccurate or incomplete. Furthermore, they are intended to help minimize taxes, not show how well the business is doing. It is crucial to conduct adequate preliminary due diligence before purchasing a business.
Beyond the financials, here are some key value drivers to consider when buying a small business:
1. The Business Has Been Providing a Steady Income for Several Years
A business that has been operating for at least 3-5 years is worth recognizing. This means the owner has been able to make some sort of living, plus pay business expenses, rent, vendors, and employee payroll.
It also means gross sales are providing enough cash flow to keep the business running smoothly. Sales drive value. This is because the real bottom line of earnings (seller’s discretionary earnings or SDE) comes out of the top line of earnings (gross sales).
A general rule of thumb for a small business that has been operating for at least three years and earns less than one million dollars in gross sales is that the owner’s benefit (SDE) could be anywhere from 10 to 20 percent of gross sales. Once a business earns over one million in gross sales, the owner’s benefit (SDE) goes down to 10 percent or less.
2. There is Potential to Grow and Expand the Business
A business is more valuable if there is potential to grow post-sale. When evaluating a business, 30 percent of your focus should be on what the owner has done and 70 percent should be what you could do with the business.
For example, it would be hard to scale if the owner is the backbone of the company as the business relies heavily on one person. For you to scale that business, you may need to put in a lot of upfront work to create process and systems to ensure it runs smoothly in your absence.
Other initial filters include:
- A strong company brand — A business with a great reputation is more valuable than one that has been damaged by a crisis or poor service. A strong brand within the industry will be more scalable.
- Market position — A business that is well positioned from its competitors has a better chance of a strong market position. These companies have products and services that are well differentiated within the marketplace.
- Quality employees — A strong business has trustworthy and highly skilled employees. Those who remain with the company long term could impact the quality of the business.
- Business revenue model — A recurring revenue model could provide steady sales throughout the year versus ones that only make sales seasonally.
- Strong and loyal customer base — An established customer base is more valuable as they are most likely to stay put after the business has sold.
3. Running the Business Works With Your Desired Lifestyle
Purchasing a business is an emotional decision as much as a financial one. If you don’t like the business or it doesn't work with your lifestyle, then it will never be a good fit no matter how valuable the business is.
Questions to ask include:
- Do I have the skills to manage the business?
- Is it in a location that I want?
- How often do I need to be physically present at the location?
- Will I need to travel often to meet buyers and suppliers?
- Do I prefer a wholesale or retail business?
- Is it the size I want (e.g. managing a lot of employees)?
Take the Time to Understand Small Business Value Drivers
Understanding the value a small business can offer for your income and lifestyle is paramount in determining what to look for when making a purchase. Once you’ve assessed the initial filters, take time to go visit the business and investigate further. You never know; the next business you visit could be a winner.