For many Americans, starting a small business is an exciting experience, and potentially financially rewarding. However, when opening a new company, owners are understandably so focused on getting off the ground that they often overlook some basic considerations that can have a major impact on the company's value down the road. Below are the five most common mistakes that small business owners make, as seen by individuals who value or appraise businesses.
1) Short-term is short-sighted
Although it can be tempting to make decisions that will save money in the short term, it's important for business owners to consider the long-term growth of their companies. Rather than saving a few dollars today, owners need to think about how to sustain growth and drive value tomorrow. For instance, owners often choose to acquire assets that reduce their company's income and allow them to take advantage of a number of tax benefits. While such strategies may save money in the short term, they also risk diminishing the future value of the company. This is because, all other factors being equal, businesses with low-to-no income are valued much lower than those with strong profit streams.
2) Put it on paper
When you go into business with someone else, whether it's a friend, family member, or the person you met at a coffee shop, it's vital to protect yourself with an enforceable partnership agreement. At the start of a business, when partners are excited and energized, it may seem like a partnership agreement is unnecessary. However, if the company hits a rocky patch, arguments inevitably arise about who is entitled to what. After the 2008 financial meltdown, business valuation experts found themselves testifying in case after case involving partnership disagreements. When creating a partnership contract, be sure to have a written legal document that all parties sign -- never rely on verbal agreements.
Furthermore, disputes can arise even when times are good and a business is doing well. For instance, if one of the partners wants to retire and sell his or her portion of the company, it's important to have a clear agreement outlining how the respective ownership interests will be divided.
3) Don't underestimate your obligations
Small company owners often don't realize that the business obligations they have taken on, such as personal guarantees, may adversely impact the value of their company. Let's say the owner of a local pizza shop signs an 8-year lease for his or her store location and then attempts to sell the company. Anyone who purchases the business will have to assume that 8-year lease, which is a huge financial obligation. As a result, the cost of the lease may decrease the value of the company, and therefore impact how much a buyer is willing to pay. Other examples of obligations that can impact value include existing contracts and leases of equipment such as machinery.
To be clear, leases, contracts and other obligations are part of doing business, and are not inherently bad. However, it's important for owners to recognize the impact such commitments can have on a company's future value.
4) All financing is not created equal
Business owners frequently need financing for operating purposes, such as paying suppliers, employees and overhead, as well as for anticipated future growth. While the requirement for funds may be significant and/or urgent, it is critical for business owners not to accept unreasonable demands from lenders or investors that would either burden the company with high interest and debt repayments or give away significant ownership control. To avoid this outcome, it is important for business owners to develop both a realistic business plan as well as sturdy relationships with dependable financial professionals and lenders.
5) Know your market
In order to determine an appropriate growth strategy, business owners must take the time to understand their market, define who their competitors are, and calculate their ability to gain control of additional customers or users given the competitive landscape. Without that basic understanding, a contemplated growth strategy may not coincide with what's best for the long-term value of the company. There are several notable high-profile examples of small companies that chose to expand too rapidly after encountering initial success. While opening more storefronts can be a positive development, it also stretches the business and creates burdensome overhead costs. Growing too fast is a common mistake of small businesses that can destroy the value of a company, and, in worst-case scenarios, can even lead to bankruptcy.
Avoiding these oversights will not guarantee the success of your small business. In fact, in some instances, what makes the most sense for your company is not in line with what will add the most value. However, it's vital to understand how various choices will impact your business from a valuation standpoint so that you can make informed decisions that will put you on the path to future success.