The problem with valuing small and very small businesses is that there is an information gap on both sides of the model or equation. 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 owners/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 businesses 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.
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 processes. 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."