14 May Barriers to Entry and Business Valuation

Written by: Gabriel Duque

(5 – 6 minute read)

When performing a business valuation, many different risk factors must be considered, 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 often benefit an existing company, as a new entrant 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. Conversely, a company operating within an industry with high barriers to entry (and potentially less competition) may benefit from a lower risk rate, resulting in an increased 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.

•  High Startup Costs*

Some industries enjoy a high barrier to entry due to the naturally high startup costs associated with doing business within the industry. Many new entrants aren’t prepared for extensive equipment procurement costs, research and development, distribution costs, marketing costs, production costs, etc. and, therefore, refrain from entering these markets. For example, amusement and recreational facilities (such as trampoline parks) require large sums of capital to acquire equipment and develop facilities capable of servicing their target markets. It is important to note that, in a business valuation, the current nature and condition of the equipment held by the business should be further analyzed. Newer, more valuable equipment can push the barrier to entry even higher compared to a business with comparatively outdated, less valuable equipment. Regardless, as not many potential competitors are able to allocate hundreds of thousands of dollars, if not more, to the development of a facility prior to generating any revenue, companies which already operate within this industry may benefit from a lower risk factor in a business valuation due to the decreased risk of new competition.

•  Intangible Assets*

Liquor Licenses

Most businesses that sell alcohol, whether for on-premises or off-premises consumption, have limited barriers to entry. However, if such a business operates in a liquor license quota state,  there may be high barriers to entry due to the limited availability of liquor licenses. In a liquor license quota state, a specific county or township is only authorized to grant a pre-determined number of varying types of liquor licenses, typically based on the population in the area. As a result, a liquor store or a restaurant with a liquor license may find itself insulated from outside competition as a potential competitor may have to, at great cost, purchase a liquor license.  Unless the number of licenses increases, usually these licenses need to be purchased from an existing business. Consequently, liquor license holders often benefit from a lower risk factor in a business valuation.

Patents & Trademarks

Patents/trademarks on a company’s product limit the ability for a competitor to enter the industry which, therefore, makes the company theoretically more valuable. In a business valuation, it is important to analyze factors such as the length of time for which the patent/trademark is in effect, how general or specific the patent/trademark is, whether the patent/trademark prevents all competition or only specific portions of the industry, and more.

Other Specialized Licenses/Permits

Other businesses may hold difficult-to-obtain, non-transferable licenses/permits, meaning new entrants must go through the process of obtaining a new license/permit. In some cases, these permits may be extremely limited in availability or already completely unavailable without the possibility of the issuance of a brand-new permit. Therefore, any company already operating within a zone with similarly heavy restrictions runs little risk of facing new competition in the area. As a result, a company which holds this type of specialized permit/license is likely to benefit from a lower risk factor in a business valuation.

•  Government Regulations

Any business working directly with the government can be susceptible to additional barriers to entry.  Contractors working directly with government agencies are, in particular, impacted significantly by government regulations and restrictions. Obtaining a government contract frequently requires a company and/or its employees to pass stringent background checks, hold special certifications or licenses, meet strict contract requirements, and more. As a result, not many businesses can meet the standards required to engage in work for the government. This can result in a lower risk factor when determining the fair market value of a company as competition may be limited.

* It is important to note that, although a license/permit or equipment may hold value, this value may not translate into a direct 1:1 increase in the Final Value of a company. On a “going concern” basis, a company receives a value which is reflective of its cash flows generated in part, or wholly, through the usage of the company’s licenses/permits or equipment. Therefore, the value of licenses/permits or equipment should be viewed as part of either the intangible assets or tangible assets components of the Final Value, which is derived in the base value of the market and income approaches. The caveat to this is in the case of a “liquidation” value, in which case the company is worth more as the sum of its assets rather than on a “going concern” basis. In these cases, the value of licenses/permits or equipment directly contributes to the Final Value of a company.

In conclusion, a business with higher barriers to entry is more valuable to an existing business owner who’s already tackled those barriers, as the barriers no longer represent an obstacle for the business. Conversely, a business with low barriers to entry carries an increased risk of competition and may therefore be less valuable. These factors are reflected in a business valuation as lower or higher risk rates, which result in higher or lower valuation multiples, respectively.