Almost everything written concerning the business world is about large, publicly-traded companies, multi-million dollar venture-funded start-ups, and billion dollar IPOs. Despite all this digital ink, small and mid-sized businesses still remain the engine of our economy.
Depending on how you define small and mid-sized, these businesses represent one half to two thirds of our economy. Two thirds to three quarters of all working Americans are employed by these businesses.
How to define “small”?
The term “small business” has most people thinking about very small businesses. Sole proprietors and Mom-and-pop businesses. The local dry cleaner, plumber, or consignment shop. But in reality, small businesses cover a large range of sizes. From the self-employed person working from home all the way to multi-million dollar enterprises.
Federal and state governments like to categorize businesses by their number of employees. I prefer using revenue (annual sales). It’s the simplest and most market-oriented way I know to categorize a business as small, medium, or large. More or less, this is how the business transaction community (of investors, intermediaries and advisers) view it:
As you can see, there is a lot of room between $100,000 and $5 million.
How many small businesses are there?
According to the U.S. Census Bureau, there are about 5.8 million U.S. businesses with paid employees. Of these, about 76% have sales under $1 million. They don’t break out $5 million and up, but I suspect 95% of businesses have sales under $5 million. So, as far as I can tell, the number of small businesses outweighs the number of medium businesses by a ratio of about 20 to 1.
As a whole, small businesses make up a large part of our economy and American jobs. So the next time you read about another billion dollar internet company (with no paying customers or profits), just take a moment to remember the contribution of small and mid-sized businesses. They are the ones providing most of the jobs in America, and driving the real economy.
If you don’t know how profitable your business is, you are not alone. Few business owners do. This is a byproduct of our accounting rules and tax laws. While accounting may be the language of business, it’s a foreign language to most business owners.
Accounting follows the money. It doesn’t tell you how much money you are making. At least, not without some digging around the numbers. Asking the right questions. Making proper adjustments.
So, why is this important? If you don’t know profits, you can’t know value.
• Market value rests on the buyer’s estimate of future profits.
• Estimated future profits rely on past profits (amount and trend).
• Thus, past profits drive market value.
So, how profitable is your business?
While “profitability” can be defined in many ways, the most common measure of profitability is discretionary earnings. These are the earnings of the business available to one owner/operator before interest on debt, income taxes, non-cash expenses, owner compensation & benefits, and normalized for non-operating and non-recurring items.
The simplest way to calculate discretionary earnings is to start with pre-tax earnings (EBT). On the typical Quickbooks Profit & Loss statement, this is called “Net Ordinary Income” found not quite at the very bottom. Then make the appropriate adjustments, as shown below:
Simplified Calculation of Discretionary Earnings
“Net Ordinary Income” (a.k.a. pre-tax earnings, earnings before tax, EBT)
+ Interest (on debt)
+ Owner Compensation & Benefits (for one full-time owner/operator)
= Discretionary Earnings
This is a simplified example. Any non-operating or non-recurring revenue and/or expenses would require additional adjustments. Multiple owners or a non-full-time single owner would also require additional adjustments.
By calculating discretionary earnings, a business owner can easily know the real profitability of his or her business.
When small business owners get busy, the default response is usually to add capacity. More employees. More equipment. More space. Yet, there is an alternative. Raising prices. It is a simple, yet often overlooked, option. A forgotten choice.
Trades, professions, and even entire industries can also be forgotten. Throughout the Iron Age and Middle Ages, blacksmithing was an important craft. Tools, weapons and other iron wares were produced…one by one…by the strong arm of the blacksmith.
Upon the advent of the Industrial Revolution, machines replaced strong arms. They could turn out the same item, but faster and more uniform. And most important…cheaper. In short order, the machinist replaced the blacksmith.
There are still a few blacksmiths around today. Instead of making weapons and tools, they make architectural and ornamental iron works. Gates. Railings. Hooks. Even decorative leaves. Some are for new construction. Some are replacement pieces. All are expensive. The custom work of a skilled craftsman comes at a price.
If you have been to a state fair or a historical re-enactment attraction, you have likely seen a blacksmith in action. Heating the iron. Hammering it. Bending it to his will.
At our state fair, we had the pleasure of meeting a blacksmith. He was demonstrating his craft to anyone who stopped by his stall. It’s hard not to stop. The hot coals. The rhythmic clang of the hammer. The orange glow of the searing hot iron. And the beauty of turning an ugly iron bar into a work of art. Not something you see every day.
With a few questions, we discovered some interesting things about this man. This was no weekend warrior or part-time blacksmith. He was (and is) a full-time commercial blacksmith. With employees and paying customers. In other words, a real business.
He explained in some detail how his business works. He classifies projects by the time they take to complete. There are only two types. Small jobs and big jobs. Small jobs take 3 weeks or less to complete. Big jobs take longer than 3 weeks.
At that point he mentioned how he was looking for new apprentices on account of how busy he was. And how hard it was to get young people interested in such an old profession. Young folks are interested in new technology. And the technology of the blacksmith is about as old as it gets.
“Well how busy are you?”, we asked, expecting the usual answers that come from small business owners. I’m working 60 hours a week. I’m months behind schedule. Typical responses. But what he said truly shocked us.
He said, “On the small jobs, the waiting list is 8 to 12 months. On the big jobs, the waiting list is 9 years.” 9 years! Needless to say, we were blown away. Apparently, he and his employees are so good at what they do, customers are willing to wait that long. It reminded us of the restaurant in upstate New York where one has to book their table 5 years in advance.
To us, this is a clear example of a time to raise prices. Most owners default to increasing capacity. Hiring another employee. Buying equipment. Leasing more space. Of course, these “solutions” often add significant upfront costs. And, in the short term, can actually decrease your capacity. New employees need to be trained. New equipment needs to be procured and installed. Adding space is always disruptive…especially if it involves moving…which it typically does.
The simplest (and usually best) solution is to raise prices. Yet few owners seem to consider this as a viable option. If the blacksmith raised his price enough to lower his waiting list to one or two years, he would still be just as busy. But he would be making a lot more money with no additional risk.
Don’t get me wrong. We are not saying that small business owners should never grow their customer base. Or add capacity. But understand this…when you add capacity, you add costs. Some you count on. Others you don’t see coming. These costs can outweigh the additional sales you add. When this happens, you can actually make less bottom line profit.
So the next time you think about “growing” the business, give equal consideration to raising prices. It just might be the better option.
photo credit: <a href=”https://www.flickr.com/photos/opedal/6038590979/”>Dag Endre Opedal</a> via <a href=”http://photopin.com”>photopin</a> <a href=”http://creativecommons.org/licenses/by-nc-nd/2.0/”>cc</a>
The Alliance of Merger & Acquisition Advisors reported a median EBITDA multiple of 5.25 for closed deals (sales, purchases, or recaps) in 2012, based on a survey of its members. This price represents the middle transaction price for lower middle market companies sold in 2012…typically those valued between $1 million and $25 million. According to the same survey of its members, AM&AA reported that 88% of its members deals were valued between 3x and 8.5x EBITDA. EBITDA is earnings before interest, taxes, depreciation and amortization, and is typically reported as an “adjusted” figure, based on generally accepted, normalizing adjustments.
Malt & Company is a member of the AM&AA, and Mr. Malt is a Certified Merger & Acquisition Advisor (CM&AA) through the AM&AA.
Everyone seems to have a New Year’s Resolution these days. Some want to lose weight. Others want to find a better job…or perhaps any job. And there are always those who resolve to quit smoking or some other bad habit for the umpteenth time. Good luck.
We suggest a different kind of New Year’s Resolution for the millions of you small and mid-sized business owners out there. And we promise it’s better than that resolution to lose 20 pounds by Easter.
Let’s face it, every one of you who owns a business will eventually retire. Some by choice. Some by circumstance. Of course, there are some you out there who plan to work forever. Well, even if you work until your last day on this earth, your spouse and/or children will still have to deal with your business once you are gone. But aside from the “work until I drop” crowd, most of you want to retire sooner rather than later. And certainly before you are too old to fully enjoy it.
Ah yes…retirement. Unlimited travel, a second home, perhaps even a third. It sounds wonderful indeed. The problem, as usual, is money. More specifically, a lack of money.
The vast majority of you have not saved enough for retirement. Yes, yes…we know all about it. The cost of college for your kids was much more than you expected. Your stocks didn’t go up. The real estate market went down. There was this, and there was that. We’ve heard it all before. But the fact remains that you haven’t saved enough…at least not enough to maintain your lifestyle and fully enjoy your retirement. We have yet to meet any business owner content on living their golden years at a reduced lifestyle.
The solution, you say, is to sell your business…and sell it for a lot of money. Cashing out of your business is your retirement plan. So you now have all (or most) of your retirement eggs in one basket (your business). Consequently, you have spent a great deal of time planning your exit with the help of expert advice…right? Wrong! We know that about 95% of you have no plan whatsoever.
Many of you dream of the day when that mythical buyer will arrive on angel’s wings…with a suitcase full of cash. We find it difficult to understand why exactly you think this way, but you do. Perhaps it’s psychological, like buying life insurance or writing your will. We don’t know. But we do know that you need to get serious about your future. You need a plan.
Don’t be like every other business owner…hoping and praying that one day you’ll hit the jackpot. Good fortune comes to the well-prepared. So prepare yourself. Start now by making a New Year’s Resolution to begin planning your exit from your business. And unlike those resolutions of the past, keep this one.