Both qualitative and quantitative factors play a role when it comes to valuing a business prior to a capital event like a merger or acquisition. In fact, overall business value is one of the biggest motivating factors for pursuing an eventual merger or acquisition. Proper M&A strategy often occurs long before the business is ever sold. It includes planning the type of business to start, properly capitalizing it and growing it toward a liquid exit.
There are essentially five general types businesses:
1. Lifestyle or Hobby Businesses
2. Community Standout Businesses
3. Promising Ventures
4. High Growth Businesses
5. Game Changers
A company’s relative positioning along the “business type” spectrum can have a large impact on the value of the company to a potential strategic or financial suitor when it comes to look for an eventual buyer. The more impact and growth a business can achieve, the more a buyer may be willing to pay.
Lifestyle or Hobby Businesses
About 80% of all businesses are lifestyle or hobby businesses. Lifestyle businesses usually have either one employee (the entrepreneur) or a handful at most. These businesses are small and manageable. They enter and exit the marketplace regularly. These businesses often lack competitive advantages and tend to be marginally profitable. As a result, these businesses are often competing against similarly situated businesses and the competition tends to be fierce. Examples of these businesses can be restaurants, beauty salons, construction firms, dry cleaners and coffee shops.
Hobby businesses are ventures in which making a profit are not the major concern of the owner. The owner derives pleasure and satisfaction from combining his or her hobby/passion with a commercial venture. The social aspects of these businesses are often a key factor in why these entrepreneurs start and operate them. Examples can include boutique vineyards, nurseries, and bars.
Three general types of lifestyle or hobby businesses exist:
Community Standout Businesses
Community Standout Businesses are modest successes and account for 15% of all ventures. They are community standouts because they usually started out as lifestyle businesses but, due to their owners’ skill or competitive environment, experienced limited competitive success. These businesses have sustained a competitive advantage against other lifestyle businesses that in their markets.
However, these businesses often lack a growth plan. They may still rely on the personal business skill of their owners. Because these businesses are moderately successful (and probably cash cows), their owners often do not make it a priority to continuously improve the business. This generates institutional inertia. Community Standout Businesses maintain their competitive position by making incremental or marginal improvements to their products and services. They may also expand territorially. Often these businesses have a difficult time aggressively expanding or steadily scaling their business because of limited funds.
Promising Ventures make a local or regional impact and account for about 4% of all businesses. Their founders purposefully created them intending to create a level of wealth and stature that could afford them multiple opportunities. These businesses usually focus on a particular market niche or specialty. They are very good at serving their niche market. Promising Ventures aim to be better than their competitors and use an aggressive incremental strategy to attract and keep customers. Essentially, Promising Ventures focus on consistently hitting singles and doubles.
Promising Ventures are not particularly inventive or have exceptional ideas – they do not produce industry changing products or services. They usually focus on continuously improving and executing well. Promising Ventures are usually scalable within the niches they carve out and usually grow through retained earnings. Larger firms generally do not find either the Promising Ventures particularly attractive because they occupy niche markets with relatively limited potential. Furthermore, Promising Ventures usually do not compete with large firms that have economies of scale because they stay safely within their niche industries.
The founders of Promising Ventures usually have extensive work experience within their ventures’ industry and use ideas culled from their prior industry experience. Promising Ventures have advantages over High Growth Businesses, despite their lower profits and scale, due to 1) they tend not to have outside investors (closely held), 2) they operate in relatively established, stable markets with limited uncertainty, 3) they do not compete against the Great White Sharks of the business world (they purposely avoid dangerous competitors), and 4) innovation is not an absolutely critical component in their industry. Promising ventures should avoid growing too fast and the temptation to venture outside their niche. Examples of Promising Ventures are Subway, Domino’s Pizza and Quality Food Centers.
High Growth Businesses
High Growth Businesses are roughly one company in a thousand. These are businesses that were created to solve large, complex problems and offer a tremendous value proposition to their customers. Examples of High Growth Businesses are Fortune 500 companies like Samsung, Southwest Airlines and Netflix. These businesses constantly search for opportunities, require a high return on there projects and often acquire Promising Ventures. High Growth Ventures have highly experienced management teams and a fully developed corporate staff. They use systematic research and analysis to decide where to allocate resources.
High Growth Businesses operate in highly competitive environments that have narrow margins for error. Therefore it is imperative that these companies stay on the cutting edge of technology, regulatory and demographic trends. In their startup phase, High Growth Ventures attract outside equity funding from angel investors and venture capital.
High Growth Businesses are capable of producing category killers – products that redefine the competitive environment within an entire market segment. Examples are Novo-Nordisk’s diabetes products or Pfizer’s Viagra. For High Growth Businesses to succeed over an extended period of time, they must satisfy three criteria. First, they must operate in markets that are large enough to permit a high level of sales and profitability. Second, the entrepreneurial team must be good enough to compete with market leaders. Third, they must innovate to attract new customers.
Only a handful of Game-Changer companies exist. They are ventures that are not scalable; they must start big and dominate from day one. Examples of Game-Changer companies are FedEx, Apple and Ford Motors (in the 1920s). To be a Game-Changer, a company must have a revolutionary idea and be the first mover in a market space and have great timing. Game-Changers are hugely profitable for their investors.
The varied nuances between the types of businesses mentioned here are vast. And, unfortunate as it may be, many a business hopes to be in the upper quadrant, but may fail to meet some of the large and scaled standards required for hyperactive business growth. What matter is building a solid team around a service or a product and selling it in the best way possible. Value may not be astronomical, but value can eventually be extracted.
Bio: Nate Nead is an expert investment banker with InvestmentBank.com. He assists companies in business valuations, mergers, acquisitions, restructurings, refinancing and capital formation projects. He has worked with businesses across a myriad of industries from technology to farming. He resides in Seattle, Washington.