At ValueStreet, investing in small businesses quantitatively means the investable universe of businesses earning less than $2 million in net income annually. The industry is much larger than this, and a business can be considered ‘small’ in the financial world with earnings up to 10 million. We see the best opportunities in the $2 million and under space, however, and have chosen to focus our efforts there for the foreseeable future.

    Core to investing in small businesses is an understanding that operating in this market requires a completely differentiated approach from public market or even ‘middle market’ private equity investing. The primary differentiator is that small firms typically do not enjoy durable competitive advantages at the industry level. As such, most small firms distinguish themselves and their services primarily via geographical barriers (localized service delivery) and superior execution, meaning that a good investment approach in the small business industry begins with a robust analysis of company-level operations and industry dynamics simultaneously.

    As small business investors who look at hundreds of potential businesses every year, we encounter different leadership styles and levels of sophistication within businesses. The structural, qualitative differences within a small business can make it more or less ‘investable; in particular, the make-up of a management team can be a key determinant of whether a sale is possible. To illustrate, consider that many small businesses are run in an ‘autocratic’ way, where orders are handed down via a single owner-manager. Often these same owners fulfill multiple complex capacities in a business making them difficult to replace. Investing in these small businesses presents a challenge to any buyer who does not possess the skills and relationships the current owner possesses. Solving these and other operational challenges are of the utmost importance for small business investors, and while success will almost never mean a billion dollar valuation, savvy investors are well compensated for the risks and challenges they assume.

    As a general rule, businesses in ValueStreet’s universe typically sell for 2-5 times annual earnings (a business earning $350,000 a year might sell for 700,000 to 900,000, or 2-3 times earnings ). To add some context, consider that as I write this, the average price to earnings ratio for the S&P 500 is 21.3 times. Intuitively, this means returns on small businesses are extremely high relative to public equities, and indeed most other asset classes. To make this more tangible, if we were to acquire the $350,000-earning business referenced above for $700,000, the implied cash-on-cash return would be 50% (350 divided by 700), while the S&P’s implied return at the above-stated multiple is 4.69%.

    Are the returns for small business investors sustainable? With the right approach and a culture anchored in execution, we believe they are.  Further, there has never been a better time demographically to be a small business investor; as the baby boomer generation nears retirement, many are evaluation transition plans that will include an outright or partial sale of their hard-earned business interests.

    If you would like to learn more about investing in small businesses, please feel free to contact us. We love to share ideas and would happy to discuss our outlook and approach to this market.