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Small and medium-sized enterprises (SMEs) are generally highly diverse in terms of size, age, industry, ownership, and business model. Furthermore, market-based comparative data is usually unavailable. Consequently, the valuation of SMEs is a complex process that differs in various respects from the valuation of large publicly traded companies.
A satisfactory and standardized method for valuing SMEs is still being sought. At the same time, the number of corporate transactions in the SME sector is growing, and with it the need for valuations that appropriately account for the unique characteristics of SMEs.
An Overview of Business Valuation Methods
In business valuation theory and practice, there are various methods that coexist and carry different levels of significance. The most important ones are outlined below:
The Institute of Public Auditors in Germany (IDW) favors the income approach, which is based on the Capital Asset Pricing Model (CAPM) and assumes, as a key premise, that the company being valued has an infinite lifespan. This is expressed through the use of a “perpetual annuity.” Depending on the length of the detailed planning period and the discount rate, the “perpetual annuity” can account for over 70% of the company’s value and thus has an enormous impact. At the same time, deriving the assumptions for a “perpetual annuity” in a plausible and methodologically sound manner is often one of the greatest challenges in business valuation.
The “Perpetual Annuity” Challenge
The basic assumption of an infinite lifespan already poses a problem for SMEs: this assumption is tantamount to assuming that the company’s underlying earning power can be transferred to a potential acquirer without restriction.
However, this premise does not apply to SMEs in many cases, as—due, among other things, to a high degree of dependence on the owner and/or specific individuals—only limited transferable earning power can be assumed. The higher risk of insolvency for a smaller company also leads to a lower probability of survival, which is reflected in the limitation of earning power. Applying the “perpetual annuity” method to SMEs would result in unrealistic or inflated enterprise values.
The IDW has also recognized the problem of applying a “perpetual annuity” to SME valuations and, as early as 2014, recommended in a practice note that the earning power of SMEs be allowed to decline over time, but it remains vague regarding the specific implementation within the context of business valuation.
In any case, there is general agreement within the German-speaking business valuation community that the cash flows to be discounted must be adjusted—e.g., through scenario analyses, a decline in earning power, or a limitation of the planning period. An adjustment via the discount rate—e.g., through a size premium—has not yet become established in Germany.
Approaches to Valuing SMEs
The modified income approach developed by the Business Administration Division of the Federal Association of Publicly Appointed and Sworn Experts (BVS) offers a potential solution that has refined the application of the income approach specifically for the valuation of SMEs (BVS Position 10-2022). It combines an intangible value (income value) with a tangible value (asset value). In determining the intangible value, the length of time a buyer would need to replicate the company’s earnings potential is of central importance (typically 1–10 years).
The BVS recommends determining this period using nine different criteria. These are:
• Owner-dependence
• Dependence on specific individuals
• Customer dependency
• Dependence on suppliers
• Product/service and industry dependence
• Dependence on financing
• Blurring of the lines between business and personal life
• Other operational risks
• Location dependence
These criteria are assessed as part of the detailed analysis of the company being valued (with the assistance of the company itself, if necessary) and evaluated using a scoring model. Practical experience with these criteria shows that it is appropriate to assign greater weight to individual criteria that are particularly relevant to the company being valued. Which criteria these are in each specific case must be determined based on factors such as the industry and size of the company being valued (measured by revenue and number of employees). The result of the scoring model determines the applicable income period for calculating the income value.
Further details on business valuation methods, as well as a practical example of the application of the modified income approach, can be found in the following white paper: Business Value for Small and Medium-Sized Enterprises (SMEs)
In order to account for the transfer of existing fixed assets—which the acquirer may also use for other purposes—particularly for companies with strong net asset value, the net asset value plays a supplementary role in the modified income approach. Here, the balance sheet values are adjusted for hidden reserves or liabilities. In this way, a partial replacement value is determined, which constitutes the net asset value component within the framework of the method in accordance with the BVS position.
Conclusion
The application of traditional business valuation methods regularly presents valuers with significant challenges when applied to SMEs. There are various approaches to addressing the specific dependencies and uncertainties associated with SMEs. In German-speaking countries, these are reflected almost exclusively by taking into account the limited transferability of earning power in the cash flows to be discounted.
A practical standard for the business valuation of SMEs, complete with concrete application guidelines, is BVS Position 10-2022, which is based on limiting the earnings period in combination with the consideration of a net asset value.
Valuation practice in the application of the modified income approach—both in the context of completed transactions and other occasions for business valuation, including court proceedings—has confirmed over many years that business values determined in this manner are, in the vast majority of cases, close to the prices that could be realized. In our view, this makes the modified income approach the preferred method for valuing SMEs.
