Barriers to Entry and Business Valuation

When performing a business valuation, many different risk factors have to be taken into account, including barriers to entry. Barriers to entry are the obstacles or hindrances that make it difficult for new companies to enter a given market. These may include patents, trademarks, technology challenges, government regulations, start-up costs, and education and licensing requirements.

Barriers to entry increase the difficulty for companies to enter an industry and thereby, restricts potential competition. These barriers benefit an existing company, but the company’s hypothetical buyer would have greater difficulty when trying to enter this industry given the advantage an established seller already has in the industry. When trying to find the fair market value of a company with low barriers to entry (and potentially more competition), the company’s risk rate will likely need to be increased, resulting in a decreased valuation of the business.

Let’s take a deeper look at a few examples of how barriers to entry affect a business’s risk rate and valuation.

  • Patent and Trademarks
    A technology company can often have high barriers to entry because of the patents and/or trademarks on the software that it sells. The patent/trademark on the company’s product limits the ability for a competitor to enter the industry, and therefore, the company is theoretically more valuable to the seller.
  • High Startup Costs
    Industries like oil, finance and medicinal industries are all industries that generally have high startup costs and as a result are also considered to have a high barrier of entry. Many new entrants aren’t prepared for such exorbitant research and development, distribution costs, marketing costs, production costs, etc. and refrain themselves from entering these competitive markets. This is why the industry which the company operates in should always be taken into consideration when applying risk to a company for its barriers to entry.
  • Government Regulations
    Governments can also add additional barriers to entry by introducing quotas, tariffs, other trade restrictions, and new regulations. These barriers also restrict competition. If imported goods become too expensive due to tariffs, then customers won’t buy them – it becomes uncompetitive when compared to domestic suppliers. Then, in an effort to get up to speed with any new regulations, it can take a business additional time, money and resources. All these governmental barriers to entry can add up to a higher risk factor when determining the fair market value of a company.

In the end, a business with high barriers to entry are beneficial to an existing business owner, who’s already tackled those barriers, thereby making their business more valuable. Although the business would be more expensive to a hypothetical buyer, there is less risk inherent in the investment since the barriers have been tackled. A business with low barriers to entry will be less expensive for a hypothetical buyer, but it comes with the increased risk of competition.