By Gray F. Smith

In the first issue of this letter I made a claim and offered no evidence for it, and didn’t much elaborate. I said that a small business sells for less than a large one in the same trade partly because the buyer cannot be sure what he is buying, and I called that gap the verification discount. Then I wrote: "The discount is not a law of nature. It is the price of not knowing."

A reader who has spent time around investors should have asked the obvious question. How do you know? This issue is my answer. It takes up one driver of that discount. There are others, among them liquidity, scale, and growth. It is also the clearest statement I can give of what I believe about this market, what I do not know, and what Workup and this letter intend to do about it.

For twenty years I invested in markets where the numbers arrive already tested. A public company’s results are audited, filed every quarter, and read within hours by analysts whose job is to say in print what they think the business earns and what they think it is worth. Investors still disagree, sometimes violently, but they disagree about the future. Nobody argues about what last year’s revenue or EBITDA was.

It is easy to treat that machinery as background. It is part of the price, and I learned that early in my career. One of my first deals as an investment banker at Lehman Brothers was working as the analyst advising Time Warner Cable on its acquisition of Adelphia out of bankruptcy. Adelphia had been the sixth largest cable operator in the country. In March 2002 it disclosed $2.3 billion of borrowings that had never appeared on its balance sheet, and three months later it was in bankruptcy. The cable systems never stopped working. The subscribers kept paying their bills. What collapsed was the market’s ability to believe the numbers, and the price went with it. The assets were real enough that Time Warner and Comcast later paid $17.6 billion for them. The lesson has stayed with me: a business and the knowledge of a business are two different assets, and the market prices both.

Warren Buffett’s line is that price is what you pay and value is what you get. The quiet assumption inside it is that you can find out what you are getting, or pay someone who can.

Main Street has no ticker, but it does have a record. I ran screens on closed sales of plumbing, heating and air-conditioning, and electrical contractors with $1 million to $20 million of revenue over the last five years, using a commercial database of private transactions. That is 471 businesses. The typical one was 25 years old, employed 11 people, and sold for $1.3 million. Five things stand out.

·      The sellers are who I said they were. Of the 243 sales that record a reason, 164 give retirement. That is two in three. The wave I described in Issue 1 is not a forecast in this data. It is the closing table.

·      The same kind of business sells at very different prices. The middle of this market, taking the median, is 3.0x seller’s discretionary earnings and 4.3x EBITDA. The averages are higher, 3.3x and 6.9x, because a handful of outsized sales pull them up, which is why I quote the median first. Around that middle the range is wide. One sale in ten closed below 1.7x seller’s discretionary earnings and one in ten above 4.6x, a spread of 2.7 times. On EBITDA the same range runs from 2.2x to 8.8x, a spread of four times. Some of that is quality. But quality that cannot be checked cheaply does not reliably get paid for.

·      Asking prices do not hold. The median sale closed at 94.5% of the asking price and the average at 90.2%. Six sales in ten closed below the asking price. One in four closed at 85% of it or less, and one in ten at 70% or less. These are the deals that closed.

·      It takes most of a year. The median sale took 253 days and the average 327. Nearly three in ten took longer than twelve months.

·      Price has barely moved in five years. The median multiple of seller’s discretionary earnings sat between 2.9x and 3.2x in every year from 2021 to 2026, and the median EBITDA multiple between 3.9x and 4.5x. The 2021 figure rests on only 16 sales, and the later years on many more. When a price does not move for five years, it is usually being set by convention. "About four times EBITDA" is what a market says when it cannot do the analysis.

Then there is size, and here the record surprised me. On seller’s discretionary earnings there is a ladder: the median rises from 2.7x for businesses with $1 million to $2 million of revenue to 3.2x from $2 million to $5 million and 3.7x from $5 million to $10 million. On EBITDA the ladder disappears. The median is 4.1x, 4.6x and 4.3x across those same three bands. Inside this market, a larger business does not earn a higher multiple of EBITDA.

The step up comes one rung higher, where private equity firms buy with full diligence teams. GF Data reports an average of 5.9x EBITDA for companies worth $10 million to $25 million and 10.0x for those worth $100 million to $250 million. Different industries and different definitions sit behind those figures, so I would not subtract one from another. Liquidity, scale and growth all play a part in that step. But it is also the first point at which every number in the deal has been tested by someone paid to test it.

In 1970 George Akerlof described a market in which sellers know the quality of what they are selling and buyers do not. His example was used cars. Buyers who cannot tell a good car from a bad one offer an average price. Owners of good cars find that price insulting and stay home. The market fills with what is left, and the price falls again. He later shared a Nobel Prize for it.

Read that paragraph again with a thirty-year-old contracting business in place of the car. The buyer cannot tell what the business earns, so he offers a convention. The owner of a good business takes a discount, or a seller note, or does not sell at all. Institutional buyers escape the trap by spending six figures on verification. On a $1.3 million purchase that option does not exist, so the uncertainty is never resolved. It is priced.

Three things, arriving together.

The cost of verification is collapsing. Reading three years of bank statements, tying deposits to revenue, and reconciling the books to the tax return used to be weeks of an analyst’s time. It is now computation. What remains scarce is judgment about what the numbers mean. The hours were always the expensive part, and the hours are what just got cheap.

Verification has become mandatory at the top of this market. Since October 1 the SBA requires a Quality of Earnings report on its larger acquisition loans. For the first time, a deal at that size cannot close on the seller’s number alone.

The buyers are becoming professional. Stanford’s latest search fund study reports new funds at historically high levels in both 2024 and 2025, and independent sponsors and family offices are working at sizes they once ignored.

When information becomes cheap, it gets bought. When it gets bought, prices begin to separate. I do not expect every multiple on Main Street to rise. I expect the spread to start meaning something: the well-run business paid for being well run, and the weak one found out before the offer and not after it.

I do not know how fast this happens. Conventions are stubborn, and five flat years of acquisition multiples say this one is.

I do not know whether cheap analysis will be good analysis. A machine-made report that nobody has signed can produce confidence without verification, which is worse than doubt. That is why every Workup report goes through Institutional Review & Analysis.

And I know the record above is incomplete in the way that matters most. It contains only the sales that closed. The businesses that never sold left no trace in it, and they are the cost of this problem.

Workup exists to be the analyst this market never had: for the buyer before the offer, for the lender in the credit file, and for anyone else in the transaction who needs the number tested before they rely on it.

This letter is where the evidence gets published. Some issues will take a view on the market and show the data behind it, as this one does. Others will teach one test on one deal. As real files accumulate I intend to publish what the record above cannot show: what sellers claimed, what survived review, and how wide the gap runs by trade and by size.

The discount is not a law of nature. It is the price of not knowing, and knowing just got cheaper and more thorough at greater speed.

G.F.S.

Workup is the analyst’s read on small business acquisition: pre-LOI screens, Quality of Earnings reports and full diligence for buyers, and Quality of Earnings reports and secondary reviews for lenders. Findings and implications. getworkup.ai

ABOUT THE AUTHOR. Gray F. Smith spent twenty years as an institutional investor at Millennium, Caxton and J. Goldman, and founded Franklin Street Capital Partners. He began his career in investment banking at Lehman Brothers, in corporate finance and M&A for communications and media companies. He is the founder of Workup. Learn more at getworkup.ai.