The problem with valuing small and very small businesses is that there is an information gap on both sides of the model or equation.¹ Small and very small businesses are just not very good at data collection, much less providing it to third parties. Most small business owners manage by walking around. In addition, the best owners have a few indicators that tell them where they stand; perhaps incoming orders and cash balance; perhaps today's cost of goods. They have their one or two simple indicators and a feel for the business. This way owner/operators can run great businesses and keep overhead down. While this limits long-term growth, it creates significant overhead efficiencies. Consequently, this lack of data makes economic and business sense.

Therefore, even “reliable” sources cannot have data that is better than what the businesses have. Having reviewed hundreds of small business financial statements and tax returns, one of the few things I am sure of is that little of the data available from small businesses meets standards that larger companies must comply with, both to keep control of the business and for compliance with requirements like employment law, safety standards, loan covenants, taxes, and so on.

Many owners drive costs down in all areas, including bookkeeping and tax compliance. The result of this is many tax returns are prepared by certified public accountants (CPAs), enrolled agents, and others who do not review the underlying financial information unless it is clearly deficient. They just enter the data. If they do review and clean up the data, adjusting entries often do not make it back to the internal books. Reviewed or audited financial statements are rare. Supplementary data beyond accounts payable and accounts receivable aging, and third party provided payroll reports are the exception.

In addition, many well-run small businesses tend not to have any formal business plan, forecasts, operating agreements, shareholder or buy-sell agreements or written direction forward. Many small business owners are convinced that these are a waste of time because they cannot predict the future. Based on the fact that most small businesses have a very limited range of products or services, limited geographic range, and have a comparably small number of customers, small business is subject to the winds of change, be it economic change, industry demand, or technological change (i.e., the Amazon effect).

There tends to be increased susceptibility to concentrations in small business. Customer concentration, supplier concentration, even referrer concentration can cause shocks to small business when the resource is lost.

Another concentration is the smaller and more limited management teams. These managers are often well trained at their day-to-day tasks but do not have broader training to move up as the business grows. This too can slow growth and create problems if someone leaves.

Yes, we could walk away from these challenges but that would not leave a lot of small businesses to value. In many cases of divorce, Small Business Administration (SBA) loans, small business sales, and other planning situations, the above limitations are ever present. After all, as of the last date when data is available, as shown in Table 3.1, 96.5% of all firms have less than $10 million of revenues, 93.6% of all businesses have under $5 million of revenues and 75.5% of all businesses have under $1 million in revenues. Clearly most businesses are small businesses. These challenges are present in the vast majority of small and very small business valuations.

This is a very different environment than larger businesses with controllers and finance officers who often produce and review sophisticated operations, accounting, and finance data. This data is then taken and either reviewed or audited by third party accountants. This produces reliable data that can be compared to other similar-sized reliable company data. Again, the comparable data set is larger, more organized companies. Clearly this improves both sides of the valuation equation (the compared and the comparables) and in many ways makes it easier to produce an accurate or at least more supportable business valuation.

Larger companies often have multiple product lines, broad geographic areas, and many, many more customers, reducing concentration risk. Planning and forecasts are part of larger businesses process. Plans are implemented and forecasts are reasonable and tested over time.

Therefore, the emphasis and focus on many small business valuations should be directed at determining the reasonableness and likelihood of future cash flows. A high level of professional judgment must be applied in making adjustments to the cash flows and in applying valuation approaches. For most small business valuations, approximate is as exact as anyone will ever get.

When valuing smaller companies, the application of common sense and judgment in determining both cash flows and proper valuation theory is essential. It is even more important than in larger businesses where financial statements are prepared by knowledgeable people and then reviewed or audited by outside firms.

Therefore, the Art of Business Valuation is to keep asking the question, “Does this make sense?” until the honest answer is “Yes.”

IS THIS A BUSINESS OR A JOB?

The independent contractor world has created a fuzzy line between a modern job and a small business. In theory, independent contractors have their own businesses. Yet, do they really? Despite what Uber is selling to their drivers, their drivers have jobs. (This is not a statement on payroll tax matters.) No matter how much money an Uber driver makes, there is nothing to sell. Uber drivers have no independent goodwill. Anyone with a suitable car and driver's license can become one. This is an easy example.

What about a dog walking business with one owner who does all the walks and makes $75,000 per year? The answer may depend on whether the owner has a contract with a company that does everything except the actual walking or if the owner has direct contracts with the dog owners. Is this a business? If the owner has multiple direct contracts (even if oral), this can be sold.

According to the Financial Accounting Standards Board (FASB), the definition of a business is:

805-10-55-3A A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. (FASB No. 2017-01, January 2017 Business combinations (Topic 805))

The FASB's definition is for use in accounting for Business Combinations. In the FASB's case, since this is for accounting purposes after a sale or purchase, the ability to sell the assets or business is assumed.

A small business exists for our purposes as business valuators when:

• Client relationships are transferable, or
• There is technical knowledge or processes that are transferable, and
• There is the possibility of making money in the foreseeable future.

Namely, “profits, people, and processes,” as my partner Eddie Davis likes to say.

At the point when the dog walking business's revenues are $225,000 and the owner handles sales functions and has other people do the walking, assuming the owner takes a reasonable salary, this looks like a nice very small business.

Under this standard there are many small businesses that look like “jobs” to outsiders or many highly paid professionals. Let's take look at a “job” that may be familiar to many valuators: Accounting practices.

There is a very good market for small accounting practices that essentially earn the owner the equivalent to a salary for mid-level professional staff at a mid-sized local firm. Most of the owner-operators work as hard as, or harder than, their equivalent at the local firm so it is not a matter of a difference in hours or dollars per hour. Perhaps the owner just does not fit in corporate America. Small accounting firms sell rapidly and easily. Apparently there are a lot of these people.

Here is an example that makes economic sense to the buyer.

The opposite has happened with small primary care medical practices. At one time there was a good market for them. Now most young physicians would rather make $150,000 with benefits by having a job rather than owning a small practice and maybe making $175,000. Because they have a choice other than being business owners to make a good living, the small medical practice has lost almost all value.

This directly ties into another essential point—who is our buyer? What are their motivations and, just as important, what will they never buy? Most important is, how does that impact the data we are comparing and the ultimate price?

This is distinct from selling assets such as a vehicle. Yes, a vehicle is necessary for a transportation business but the fact that it was or can be used in a business does not make the car a business. For most small businesses, the tangible assets are comparatively easy to obtain and, while necessary, they do not usually contribute much to business value.

Similar but different is the very high level of technical skills that cannot be transferred. A fine artist could have a wonderful “business” or practice or career but great difficulty in its transfer. Relationships and technical knowledge, if they can be duplicated and transferred when they produce income, have business value. Again, back to Eddie Davis: “profits, people, and processes.” Many independent contractors will fail this definition of a business because the client is not transferable or the technical knowledge is not transferable.

Some may meet those standards but not have the possibility of making enough money to transfer. It is difficult to transfer small dollar amounts of relationships and technical knowledge. For many very small businesses, the training and transition costs are higher than the entire likely business value. Buyers have a similar issue with the amount of effort to perform due diligence. Often due diligence costs are more than the very small businesses is worth. Particularly if you have to perform due diligence on three or four businesses to buy one. This is an effective barrier to business value in very small businesses. In those cases, the client at best has a business with no value or more likely has a job.