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Avoiding the ‘Small Business’ Trap

Les Nemethy looks at the challenges of doing a deal with a small company.

Running a small business is arguably more difficult than running a large one. I have done both, and that has certainly been my experience.  

When running a large company, you have resources: specialized staff, better systems, in general, more resources to solve problems as they arise.

When running a small company, it is often difficult to afford high-powered staff. A small company might be lacking certain functions altogether, such as controller, HR director or in-house counsel. If a small company loses a key staff member, it usually leaves a gaping hole; where a larger company loses a key staff member, one can usually promote someone from within.

In a small company, the CEO often has to be a jack-of-all-trades, chief cook and bottle-washer, filling several operational functions at once.

But this article is not so much about managing small companies, rather about doing transactions with small companies, whether raising equity or selling the company or, as will be discussed below, merging two small companies.

It is also much more difficult to do transactions with smaller companies than with larger companies, for the following reasons:

•    The greater difficulty of managing small companies, as explained above, makes them higher risk, and hence less desirable, to investors;

•    Ironically, it is often easier to find buyers for larger companies than for smaller companies. Strategic investors and private equity firms prefer targets that “move the needle”, that have a certain critical mass. In my experience, this threshold usually kicks in at a transaction valuation in the range of ten million euros or dollars;

•    It takes just as much time and effort, sometimes more, to buy or sell a company valued at EUR 2 mln as a company valued at EUR 20 mln;

•    As an owner of a small company (say EUR 1 mln-2 mln revenues), it is often difficult to afford an experienced law firm for a transaction, let alone a good financial advisor, who might be used to earning a success fee of several hundred thousand euros;

•    For buyers, investing in a small company, that often has a very “thin” management team, can be a high-risk proposition. If one or more members of such a thin management team leave, or turn out not to meet expectations, the entire investment may be at risk;

•    Small companies often lack audited statements, or any kind of management accounting;

•    In any transaction involving a smaller company, it is often challenging to obtain timely and quality information, due to lack of systems, specialized staff (such as a controller), etc. This can cause enormous strain on the management team of a small company, as well as in the negotiations between the parties;

Furthermore, the valuation of larger companies is often more advantageous than for smaller companies, frequently commanding substantially higher multiples of revenues, cashflow, earnings before interest, tax, and depreciation, etc.

Become Bigger

So what can a small business owner do in order to improve valuation and the chances of doing a transaction? Become a larger company:

Growing the company organically to a larger size, so long as that growth can be done profitably and without endangering the financial health of the company, might be one approach.

Acquiring other companies might be another way of growing—obviously, the acquisitions should be value accretive rather than diminishing value.

A merger is another option to increase size, one which is perhaps not applied as often as it might be. It is entirely possible to merge two smaller loss-making companies and create one profitable larger company. This requires careful financial engineering, and a good mix of management skills and human resources.

Finally, you could qualitatively improve the small company, to have it run more like a large company (e.g. with a high quality management team, better systems, better corporate governance).

In a nutshell, doing a first transaction with a small company can be even more challenging than managing a small company. Finding expert legal and financial assistance that is capable of working within the budgetary constraints, is also an important ingredient to success.  

Most owners will typically attempt such a transaction themselves, with the assistance of legal counsel. Often it ends up being a “learning experience” rather than a successfully closed transaction.

Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.