This is a follow on post from BFM -3: Return on Small Business Equity. The ROE is only useful as a metric if you know the hurdle rate for small business equity. This is not easy to compute for small businesses.

There are a number of reasons and many are intuitive:

  • The shares do not trade on any market and there is no metric that can be used to arrive at a price/earnings multiple for placing a valuation on equity.
  • There aren’t many small businesses that pay dividends.
  • There aren’t many small business entrepreneurs who ever want to sell their shares.
  • Small business equity is based on perspiration not inspiration like publicly traded companies where the market picks winners and losers.

So how does one place a hurdle rate or cost on the equity in a small business? I use the following analogy and this may put this issue in a different perspective.

“.. You have $300,000 in free capital and are asked to invest in .. your own business.” However here are some caveats:

  • Other than knowing the industry and local economy in which the business operates you have no emotional attachment to the company.
  • The $300,000 would be tied up in the business for 15-20 years.
  • There would be no dividends paid or shareholder loan repayments.

So if you were evaluating this investment, what would your requirement be for a rate of return? It certainly wouldn’t be 10-15%. The risks would be astronomical. I venture a guess that you would want about 25%+ annual ROE before you even thought about this. Maybe the rate could be quantified as follows:

  1. Risk free rate of return                            3.5%
  2. True inflation rate                                      5%
  3. Business specific risk                                2%
  4. Financial risk                                               3%
  5. Economic risk                                             2%
  6. Management risk                                       3%

The total of those risks is 18.5%. How is the business capitalized? If the capitalization rate 1.5:1 – 2.5:1 or greater. Simply multiply the 18.5% by the capitalization rate to get a good idea of what the true cost of equity capital is for a small firm. It will also become obvious why small companies cannot raise additional equity capital.

So our previous example showed an ROE of 14% for the business. If the Cost of Equity is 25%+, management and the business is simply spinning their wheels.

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