How to Look at and Evaluate a Small Business
When it comes to buying a business, you simply cannot use big business rules to value and buy a small business. If we compare small businesses vs big businesses, not only is there a wide disparity in gross earnings, but also in how they operate and show their financial performance. Before you begin your journey in buying a small business, you must first understand the differences between small and large businesses and why size matters.
Small Business vs Big Business: What’s the Difference?
1. They Make Their Money Differently and They Operate Differently.
Big businesses, those with gross earnings ranging anywhere from a few hundred million to a few billion dollars, are predominately publicly traded companies. They make money not only by selling their products and services, but also shares of stock. In addition, their financial statements must be formally audited and publicly reported on a quarterly and annual basis. The owners (stockholders) receive earnings reports, but have no direct involvement in the company. They are run by a team of executives who are accountable to the board of directors.
In contrast, small privately owned businesses, those with gross earnings under 30 million dollars, make their money by selling only their products or services. These businesses are not required to have their financials audited or report their earnings, yet the owner may use the financials to help manage the business. In most cases, the owner has some level of involvement in the day-to-day operations. In very small businesses, the owner is not only the manager, but also the sales person, stockperson, bookkeeper and janitor. A small business owner is not accountable to anyone but him or herself.
2. Their Financial Records Are Meant for Different Purposes.
Big businesses, those that are publicly traded and owned by shareholders, want to show their earnings. They want to show how well they are doing so they can sell shares of stock. Their quarterly and annual reports may show positive news to shareholders in pre-tax profits, but their tax returns may tell an entirely different story. When it comes to earnings potential, big business financial performance is typically measured by EBITDA, which stands for earnings before interest, taxes, depreciation and amortization.
In the world of small business, financial records are produced primarily to minimize taxes – not to sell the business. Yet, they do reveal a lot of information about financial performance and earnings potential – you just need to know how to look at it. When looking at small business, earnings potential is measured by SDE, which stands for seller’s discretionary earnings, or seller’s discretionary cash flow. Put it another way, sales drive value and gross sales help determine the value of a small business.
3. Business Size May Affect Its Potential Earnings.
Although gross sales can be a reliable method for determining the value of a business, higher gross sales do not necessarily equal higher value. Once a business earns more than one million dollars in gross sales, their potential earnings can go down significantly. This is because they cost more to operate. They have more managers, employees, inventory, and sometimes thinner profit margins.
If you’re looking at a small business that earns less than one million dollars in gross sales, a good rule of thumb for determining its potential earnings or SDE is somewhere in the ballpark of 10-20 percent of gross sales. Yet, if you’re looking at a larger business that earns over one million dollars in gross sales, the potential earns or SDE goes down to roughly 10 percent or less of gross sales.
A Savvy Business Buyer Asks Questions and Does Their Homework.
As a business buyer, one of the biggest questions you will have is, ‘How much money can I make? Understanding the true value of any small business requires a savvy business buyer who knows what to look for. If you like what you see, then speak to the owner and learn more, it may just be a business worth buying.
Next Step: Get the Guide to Buying a Small Business
This free, 100-page digital book provides step-by-step instructions for buyers.