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How To Use Small Business Value As The Ultimate Performance Indicator
By David Coffman
Business performance measurement and management promote the use of carefully selected key performance indicators to evaluate the performance of a company, its management and employees. Management theory has long recognized that the primary purpose of a company’s management is to maximize shareholder value. For large companies with stock that freely trades in public securities markets, this is a simple process of monitoring stock price. For small, private companies the situation is quite different.
Large, public companies have many stockholders that elect a board of directors, who in turn hire the key executives. This separation of ownership from management does not exist in small, private businesses. Often these three groups (owners, directors and management) are comprised of the exact same individuals. Small businesses become extensions of their owners in many ways including their objectives. Owners are typically more concerned about objectives like: minimizing taxes, maximizing personal income, maintaining personal lifestyles, minimizing the assets held within the business, and protecting personal assets. Pursuit of these objectives tends to minimize the value of small businesses. Owners often are not very interested in the value of their businesses until something happens that makes it important like a divorce or wanting to retire.
Do small business owners really not care about business value? Or is it because they are not accustomed to having it available? Business valuations cost thousands of dollars, so small businesses can’t afford to get one on a regular basis. If it is not practical to measure something, it becomes unimportant. If the value of small businesses were readily available, like public companies, then the owners would become interested in it. Quite possibly they might shift their business objectives to maximize value.
Those who have tried to monitor business value without paying for regular business valuations often used industry “rule of thumb” formulas. While formulas are easy to use they have some serious drawbacks. They are based on data of unknown quality and quantity. The formulas are expressed in ranges that produce widely varying values. They do not take into consideration the unique facts and circumstances of each specific business.
There is a better solution. Much more information is now available about the sales of small, private businesses. There are a number of sources that have collected data on thousands of transactions over many years. These databases provide actual market data. Professionals and commonsense suggest that quality market data is the best source for appraising any property. The databases have some shortcomings, too. The information is limited to basic data like annual sales, asking price, cash flow, selling price, etc. And some types of businesses don’t have many transactions. The databases work best when there are many similar transactions, so common businesses like restaurants are good candidates. Averaged figures from many transactions offset any extreme or unusual cases. The ratio of selling price to annual sales, or selling price to cash flow is typically used to calculate a specific business’s value.
These databases are available by subscriptions that are not cheap. So it is not practical for a small business owner to access them directly. And the professionals who do subscribe aren’t prone to sharing them. There are a few companies that for a small fee will search the databases for transactions involving similar businesses, calculate the average ratios, and use them to calculate the value of a small business. These low cost business valuations based on actual market data are great tools for making business value readily available for most small businesses. Using this tool, small businesses can finally start using business value as the ultimate performance indicator, just like public companies.
About the Author
David E. Coffman is a Certified Public Accountant (CPA) who is Accredited in Business Valuation (ABV) and a Certified Valuation Analyst (CVA). His firm, Business Valuations
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