Understanding the complexities of business valuation is a crucial aspect of strategic decision-making and achieving long-term success for all businesses. Understanding the range of factors that influence the value of your small business is crucial for making informed choices, and can enable you to enhance the value of your business. One significant factor to appreciate is the size effect, which highlights the impact of the scale of your business on its valuation. Here we discuss the size effect and explore how it affects small businesses, providing actionable insights and real-life examples.

Simply put, the size effect is the observation that smaller firms have a higher rate of return than larger firms. As a consequence, the larger the firm, the higher the multiple that would get applied in a valuation.

The reason for this is that smaller businesses are riskier, on average, than larger firms in the same industry and geography. The higher the risk, the higher the capitalisation rate, and therefore the lower value.

This effect is well demonstrated in listed stocks, and while it is observed in private companies, there is no definitive study that has shown this in smaller private businesses. Furthermore, there is no formula that can be applied to factor the value of large firm down to an otherwise similar small firm.

This is clearly a reflection of the unsystematic risk included in the discount rate given the other factors that make up the discount rate are presumably unchanged (e.g., the risk-free rate, any risk incorporated for geography or industry). Investors – in this case the business owners – (need to) demand a higher return to compensate for the significant additional risk of small business ownership. Small businesses that do not – and cannot – provide this premium ROI will fail to attract investment.

Top 10 Factors that Increase Risk in Small Businesses

Small businesses are, on average, riskier than their larger counterparts due. Here are the top 10 factors we typically see in New Zealand small businesses.

1. Limited Financial Resources:
   Small businesses typically have access to fewer financial resources than larger firms. Limited capital makes it far more challenging to weather unexpected financial setbacks, such as a sudden decrease in revenue or a significant unexpected expense. Access to debt can also be challenging, requiring cross-guarantees with the owners’ personal assets, and having to pay higher rates on their borrowing.
2. Narrow Product and Service Portfolios:
   The offerings of small businesses tend to be less diversified, often they have to rely on a single product or concentrated customer base. This lack of diversification leaves these firms more vulnerable to changes in the market or in customer preferences. Coping with economic cycles can imperil the viability of small businesses.
3. Intense Competition:
   Most markets are dominated by a small number of large competitors, and a large number of small firms, resulting in intense competition. Competing with larger companies that have deeper pockets and larger market presence if often challenging and risky.
4. Regulatory Compliance:
   Smaller businesses typically lack the resources to ensure compliance with the laws and regulations that govern their industry. Non-compliance is not an option, although small business owners may skirt the rules where they can. While any business can look to outsource aspects of their compliance, it is generally the regulatory obligations across the business that are expensive to implement.
5. Access to Talent:
   Competition for talent in many industries is extreme. Attracting and retaining appropriately skilled employees is generally more challenging for small businesses. They often cannot match salaries and benefits, and roles are often require broader skills than similar roles at larger firms. Career progression is also typically limited.
6. Resilience:
   In addition to a lack of diversification, small businesses are often less resilient than their larger counterparts. Supply chain issues, loss of a major customer, or the entry of a new competitor can cause turbulence in the market, even if only for a short period. A lack of resilience to these (often temporary) changes can cause business failure.
7. Limited Bargaining Power:
   Across the supply chain, any power imbalance between supplier and purchaser reduces the bargaining power on the weaker party. In most cases, the weaker party is a small business. They find themselves unable to leverage bargaining power when negotiating with suppliers or customers, resulting in less favourable terms, lower margins, and therefore reduced profitability.
8. Management Depth:
   Small business owners wear multiple hats and often lack the time and expertise to stay on top of the range of issues the business faces. This results in increased business risk due to operational inefficiencies and bounded options available to the firm (ie., the owner doesn’t have the skills to implement necessary systems and process, or evaluate options effectively). Furthermore, small firms also lack ‘bench depth’ – they are dependent on a small workforce often lacking cross-training to step into other roles when necessary.
9. Dependency on Key Individuals:
   It is very common for small businesses to rely heavily on the knowledge, skills, and relationships of a very small number of key individuals, including the owner or founder. If these individuals become incapacitated or leave the company, significant operational disruption occurs.
10. Systems, Tools, and Innovation:
    Many small businesses simply cannot afford the types of systems and tools that larger firms use to drive capabilities and efficiencies. Small businesses need to find ways to ‘make do,’ generally using manual processes or outdated systems. Furthermore, keeping up with technological advancements and innovation is almost impossible for small businesses with limited R&D budgets. Falling behind in technology adoption can quickly result in a loss of competitiveness.

There will always be additional factors peculiar to particular businesses and industries – and some of these may not apply to your business – but this list should give you a sense of the types of disadvantages small businesses have over their larger competitors. In all cases, we need to focus on the additional risk of the business due to the impact of these factors.

Small Business Benefits

To counter the factors above, small businesses can also have the advantage of greater agility and adaptability, the potential for faster growth, and much higher levels of energy and passion from the founders and their small team.

In addition, many of the issues above can be at least partially managed and mitigated through careful planning, a focus on customer needs, and recognition of the issues.

Small businesses face a higher level of risk than larger businesses. This heightened risk is reflected in the expected rates of return on investments in small businesses, which corresponds to lower business values independent of the level of earnings. Small business owners should understand the size effect, and have an appreciation for the risk factors that underlie this discount. By focusing on the factors likely to decrease the riskiness of their firm, small business owners can increase the value of their business. These factors go hand-in-hand with growing their business.