Negotiating the Price of a Small Business: Part 5

Part 5: Understanding price implications of industry fundamentals

 

This is Part 5 of a multipart blog series on negotiating the price of a small business. If you missed the previous posts, click here.

 

Beyond the characteristics of the target company’s business model, there are certain “macro” industry fundamentals that small business buyers like to see. The presence (or absence) of these characteristics may influence negotiations and put pressure on price when it comes to buying or selling a small business. These include:

 

  1. Size. A business that’s tackling a larger addressable market is almost always seen as more valuable, not only because it provides more direct runway for growth, but also because it usually offers more indirect opportunities to expand or pivot into adjacent sectors.
  2. Growth. A small business that sits in an industry that is growing quickly, or at least steadily, is typically seen as more attractive, because even if the company is average, the “rising tide” should enable it to keep growing.
  3. Disruption. Somewhat counter-intuitively, a business that operates in a stable, lower-tech environment is often seen as more valuable, because it leaves the business less susceptible to rapid disruption, and the revenue loss and asset obsolescence caused by such innovation.
  4. Fragmentation. A business that operates in a fragmented industry, with many small(er) and less sophisticated or coordinated firms, is often seen as more attractive, because there is perceived room to displace or consolidate weaker players.
  5. Regulation. A business that operates in a relatively unregulated industry is almost always more valuable because it means less “red tape” and compliance cost, but also, more fundamentally, less risk of the industry experiencing upheaval from unexpected or arbitrary regulatory change. 
  6. Cyclicality. Cyclicality speaks to how much an industry’s growth rate is correlated with movements in the overall economy’s performance. Typically, a business that has little cyclicality in its profits (or even better, counter-cyclicality, so it does better even if the economy is doing worse) is considered more valuable, because its profits are more reliable.
  7. Seasonality. Seasonality is similar to cyclicality, only it relates to correlation with the changing of the seasons, not the movements of the market as a whole (e.g. a ski resort). A small business that has little or no seasonality is typically more valuable, because it earns profits steadily all year long, and is at less risk of a short “make or break” period where things can more easily go wrong (e.g. a winter with very little snowfall for a ski resort).
  8. Location. Geography is a critical overlay of all the industry factors listed above. Any combination of these factors – particularly size, growth, regulation and currency stability – can be materially different across national (or even regional) markets where a business operates. Taking a holistic view then, a small business that operates in a geography (or geographies) where industry factors are more favorable will typically be considered more valuable than similar businesses that operate in relatively disadvantageous markets.

 

It is rare to find a business that operates in industry segments that displays all of these characteristics. Indeed, many of them are well outside the control of any specific company. But, to the extent that a target company understands these all, and has put proper risk mitigation strategies in place to minimize their impacts on cash flows, the seller of a small business is in a good position to negotiate the price up. Conversely, if all of these industry factors move against the target company, and there is no way to reasonably overcome them, the seller can expect to get pushed down on price.

 

To learn more, keep reading Part 6 in our Negotiating the Sale of a Small Business series, where we look at the financial characteristics of a target company that can enhance value. A reminder: a complete version of this content is available to EquityMaven’s subscribers in e-book format.