Size and scalability is a key value driver for most businesses. Larger businesses are perceived to be more substantial and stable organizations than smaller companies. These businesses have found a way to grow beyond the efforts of the owner(s) and become less reliant on the owner.
Investors consider smaller companies to be riskier than larger organizations. From a valuation perspective this additional risk is reflected in the capitalization rate (i.e. inverse of the multiple) as a size premium. A size premium increases the capitalization rate which equates to a lower valuation multiple and, therefore, lower value.
According to Ibbotson SBBI, the size premium represents the additional risk inherent in small public company stocks as compared to larger public company stocks. For example, the risk premium associated with micro-cap stocks (where the largest micro-cap company had a market capitalization of $1.2 million) is approximately 4%.
A company with a scalable business model will be more valuable. Growth and scalability, however, is a challenge for many small businesses. Is there sufficient demand for your products/services to support growth? Do you have the resources to support the increased demand? Do you have the input supplies required to support the increased demand? Do you have the management team in place to manage the increased resources required to meet the increased demand? Does your business have the infrastructure necessary to scale its operations?
What would have to change in your company for it to handle 5 times the current number of customers?
Business owners looking to build a business to sell one day should consider the company’s scalability potential. Some of the options to consider include:
- Geographic Scalability - Will your business model work in another city?
- Cultural Scalability – Will your business concept work in another culture?
- Horizontal Scalability – Can you leverage a brand by selling new products/services to your existing customers?
- Vertical Scalability – Does your business have the infrastructure in place to provide existing products/services to new customers without increasing the variable costs?
Although there is a market for main street businesses, larger companies are perceived as less risky and therefore more saleable. Demonstrating a business’ scalability is one of the keys to driving a premium price for the company when it comes time to sell.
If you are building a business to sell one day and are curious to see how your business ranks on the key value drivers considered by potential purchasers, take the 13 minute Sellability Score questionnaire: