Business valuation - Definitions and Distinctions

There is no absolute quantitative or qualitative definition of what distinguishes a big business from a small business. The only fact that may be unambiguous when comparing big and small businesses is that the distinctions are based on many factors, not just on size alone. For purposes of this discussion only, we will classify big businesses as those that generate more than S5 million in revenues and where equity ownership is typically with individuals who are not employed by the company. We will classify smaller businesses as those that generate less than 85 million in revenue and where employees and/or family members are the principal equity owners. Also for definitional purposes, in big businesses, the company is expected to survive the current owners.

In small businesses, the company may not survive an ownership transition (or, at least, not without some significant organizationa disruption). Generally, a big business operates as a business institution with organizational qualities that are distinct from the abilities of the em- ployee/owners. An example of such a big business may be a law firm with 250 lawyers. A small business operates more as a convenient association of individuals/practitioners—with organizational qualities that are directly dependent on the abilities of the employee-owners. An ex- ample of such a small business is a law firm with three lawyers.

Big businesses usually operate as a separate entity (from legal, accounting, and taxation perspectives) from the owners. But in the typical small business, the business operations are often inseparable (financially, legally, and organizationally) from the employee-owners.

In a big business, employees are paid market-derived salaries and wages for their services, and the equity owners receive a nonwage return on their equity investment. This return on equity investment comes in the form of dividends or other profit distributions. Accordingly, the compensation for services and the return on equity ownership are separate. This is true even if the same individual is associated with the big busi- ness both as an employee and as an equity owner.

However, in the smaller business, employees/owners are not always paid market-derived wages. And the equity owners often pay out all of the profits generated by the small business to themselves as some form of compensation bonus. Accordingly, in the case of small businesses, the compensation for employment services and the return on an equity ownership investment may be inseparable.

Concerning operational management, there may be outside board of directors members and outside corporate officers and other senior man- agers in big businesses. By "outside" in this context, we mean directors and executives who are not themselves substantial equity holders in the business. In contrast, all board of directors members, corporate affili- ates, and senior management are insiders at a small business. Within this context, we define insider as a substantial equity holder in the business. With regard to the quality of historical financial data, large businesses typically have financial statements that are prepared in compliance with generally accepted accounting principles (GAAP). These financial statements are often audited by independent certified public accountants. The footnotes to audited financial statements will provide a great deal of supplemental data regarding the company's results of operations and fi- nancial position. These supplemental data can be extremely useful to the business valuation / Business Appraisal analyst. And the footnotes to audited financial statements will describe the accounting principles upon which the financial state- ments were prepared.

This description of accounting principles is also extremely useful to the business valuation / Business Appraisal analyst. It allows the analyst to more full understand the basis for the financial statements that will be used in the valuation. Small businesses may not have financial statements prepared in ac- cordance with GAAP. And the financial statements are often not audited by independent certified public accountants. To the extent that the small business financial statements are examined at all by certified public accountants, they may be reviewed or compiled rather than audited.  

Large businesses often use one set of accounting principles for the preparation of financial statements and another set of accounting prin- ciples for the preparation of income tax returns. Small businesses, on the other hand, may use their income tax accounting principles in the preparation of financial statements for all purposes. In fact, in the case of very small businesses, the business may not prepare financial statements separate from its income tax returns. Often in these cases, the only historical data the analyst has to work with are the historical in- come tax returns of the business.

With regard to the quantity of historical financial data, large businesses typically have more data than small businesses do for two reasons. First, as mentioned above, there is a considerable amount of upplemental data presented with audited financial statements. These data are simply not presented with reviewed or compiled financial statements. And with regard to very small businesses for which there are income tax returns only, the quantity of historical financial data will obviously be limited. Second, larger businesses have typically been around longer than smaller businesses.

Therefore, the business valuation / Business Appraisala nalyst may be able to collect and assimilate 10 years or more of financial data for a large company. On the other hand, the business valuation / Business Appraisal analyst may not be able to collect and assimilate even five years of financial data for a small company.