How big is small?

Most of us have heard of the Small Business Administration. Many universities have Small Business Development Centers. Congress says they want to help "small businesses." Few of us, however, have ever heard "small business" defined. A small business can consist of just one person or in some cases 100 people. But at what point does a small business become a mid-sized business or a large business? There are some organizations and agencies that define a small business as one having fewer than 100 employees and less than $10 million in annual sales, even though there are many small businesses that have annual sales in the $15million to $20 million range. Most small businesses have similar characteristics including some of the following:

* Ownership is vested in few people.

The owner, not a board of directors, has the last word in making decisions.

* The owner usually has his/her own money invested rather than investor's money.

* The owner's borrowing power and sources of funds are limited. Personal guarantees are usually required.

* The owner wears most of the hats and there is a limited level of management.

* The reason for ownership is usually because it is a means of earning a livelihood with a degree of independence.

* Financial information is highly confidential and not available to the public.

The majority of businesses being bought, sold, financed and appraised today are in the small business category. It is estimated that 52 percent of those employed today are employed by small businesses. Small businesses are not often valued in the same way as larger businesses. The standard of value being sought in most cases is fair market value based on the principle of "what a hypothetical buyer will pay and what a hypothetical seller will accept, for a similar or comparable business." This suggests that a market approach is critical to establishing fair market value. "Fair market value" should not be confused with "fair value," which is a totally different concept.

It is not difficult to estimate the fair market value of real estate. The information about the details of the property (rooms, baths, square footage, lot size, taxes, etc) and their selling prices are readily available through public sources (county records) and through private sources (Multiple Listing Services, plat maps, title company services).

It is totally different when it comes to a business. There are no public records. Without reliable financial information (financial reports) and transaction information (escrow documents), it is not possible to guesstimate the purchase price and/or what was included in the purchase (accounts receivable, inventory, fixed assets, etc.). There are however, private data banks that accumulate and analyze financial transaction data. The information is available through membership or subscription.

Transaction data gathering begins with identifying the business' SIC (Standard Industrial Classification) Code Number as listed in the Standard Industrial Classification Manual of the U.S. Office of Budget and Management. All business and profession types (over 5,000) have been assigned a number by the U.S.

Office of Budget and Management. Transaction data is gathered from business brokers, merger and acquisition brokers, lenders, accountants and others who have taken part in transactions, and are classified under these numbers. For example, under SIC No. 3443, "Manufacturing, Fabricated Structural Metal Products," there are 111 types of businesses that fabricate metal products.

In order to determine what businesses have sold for, the appraiser must research private transaction data banks that deal almost exclusively with closely held, private businesses. The appraiser looks for data on businesses that are comparable or similar, not necessarily identical, to the business being valued. Even though there may be little, or no, specific data on the manufacture of buggy whips, comparable data can be found in SIC No 3199, "Manufacturing, Leather Goods Not Elsewhere Classified."

The classic case is that of Joyce C. Hall, the founder and sole owner of Hallmark Greeting Cards. In The Estate of Hall v. Commissioner, the IRS claimed that the only comparable data to Hallmark's was that of American Greeting Cards. The estate established value using data from MacDonald's, KFC, Pilot Pens and about 30 other companies. Although not in the identical business as Hallmark, the estate established that those businesses were similar in many ways (operations, marketing, customer appeal). Their position was upheld by the courts and the case is used today as a model by appraisers.

From reported transaction data, ratios, multipliers and capitalization rates are developed that can be applied to gross revenue, discretionary earnings, EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization), cash flow, and other forms of income.

Users of valuation services are often confused by the terms "capitalization rate" or "multiplier." They are both means of arriving at the value of revenue or an income stream. One is actually the reciprocal of the other. A multiplier, whether applied to gross revenue, or an income stream (discretionary, EBITDA, cash flow), estimates the number of years it will take for owners to get their money back. A return over four years is equal to a 25 percent return each year. Income streams are therefore either multiplied or divided to arrive at the value.

For example:

Income stream: $1,000,000

Multiplier: 4

$1,000,000 x 4 = $4,000,000

Income stream: $1,000,000

Capitalization rate 25 percent

$1,000,000/25% = $4,000,000

Discretionary earnings are those financial benefits that an owner puts in his/her pockets, one way or another. This could be in the form of salary, tax write-offs, perquisites, personal insurance, non-operating and non-recurring income and/or expenses.

The data bank information may come from businesses of various sizes, in varied locations and from varied time periods. However, empirical studies indicate that those variations have little impact on the capitalization or multiplier rates. It should be noted that not all data banks report in the same way. Data from some banks may include the value of inventory and fixed assets as part of the multiple or capitalization rate, while other data banks may exclude the value of inventory and fixed assets in the multiple or capitalization rates. The appraiser must make adjustments in those instances.

After arriving at the value, the appraiser must then put that value to the test through a series of examinations for reasonableness. The ultimate test must answer; "If the business is sold at the appraised value, and on market terms, will it pay for itself, pay the owner a reasonable compensation and still leave over a reasonable return on the investment?" If not, then it's back to the drawing board.

Jerry F. Golanty, owner of BizVal in Reno, is a governor of the Institute of Business Appraisers. Contact him at 332-4881 or jerrygolanty@bizval.net.