How to Value a Business

Buyers pay for earnings, not revenue

A business with revenue of two million dollars a year and clearing eighty thousand is worth considerably less than one with revenue of six hundred thousand and clearing two hundred and twenty. Revenue tells you how big the operation is. Earnings tell the buyer what they get to keep, and that is what they are buying.

So the first real job in any valuation is working out what the business genuinely earns for the person who owns it. That number is almost never the profit figure at the bottom of your tax return, because that figure has been shaped by years of legitimate tax planning that understates what the business actually produces.

SDE or EBITDA, and why the difference matters

There are two earnings figures in common use, and picking the wrong one is the single most expensive mistake sellers make.

Seller's discretionary earnings (SDE)

What a single owner-operator takes out of the business in total: profit, their own salary, and the personal benefits that run through the books. It is the right measure for owner-operated businesses, which in practice means most businesses earning under roughly a million dollars a year.

EBITDA

Earnings before interest, tax, depreciation and amortization. Crucially, it is calculated after paying a manager the market rate to run the business. It is the right measure once a business is big enough to have real management in place and the owner is no longer working in it daily.

The rule of thumb is simple. If the owner works in the business every day, use SDE. If a salaried manager runs it and the owner oversees, use EBITDA.

The reason this matters so much is that the two carry completely different multiples. EBITDA multiples are higher, because EBITDA is a smaller number once you have paid a manager out of it. Applying an EBITDA multiple to an SDE figure produces a price that no buyer, and no lender, will agree to, and it is the fastest way to make a listing look unserious.

Working out your SDE

Start with net profit as filed, then add back the things a new owner would not inherit. The usual add-backs are:

• One working owner's salary, plus the payroll taxes on it
• Personal expenses running through the business: vehicle, phone, health insurance, travel that was not really for the business
• Interest, since the buyer will have their own financing arrangement
• Depreciation and amortization, which are accounting entries rather than cash
• Genuinely one-off costs: a lawsuit, a relocation, a major equipment purchase expensed in one year
• The difference between what you pay yourself in rent and the market rate, if you own the building

Just as important is what you cannot add back. A second working owner's replacement cost stays in, because the buyer will have to pay someone to do that job. So do the salaries of any staff the buyer needs to keep, and any expense that is going to recur no matter who owns the place.

Document every add-back before you list. A buyer's accountant will ask for proof of each one during due diligence, and anything you cannot document gets struck out. Losing twenty thousand of add-backs late in a deal does not just cut twenty thousand from the price, it cuts twenty thousand multiplied by whatever multiple you agreed, and it costs you credibility on every other number you have presented.

Which multiple applies

Once you have a defensible earnings figure, the price is that figure times a multiple. Most small owner-operated businesses trade somewhere between two and four times SDE. Larger businesses with management in place and cleaner reporting trade at three to six times EBITDA, sometimes more.

Industry moves the range around. Restaurants and food businesses tend to sit at the low end, often between one and a half and two and a half times, because margins are thin and failure rates are high. Professional services, anything with contracted recurring revenue, and businesses with real barriers to entry sit at the top of the range or above it.

The important thing to understand is that a multiple is not a rate card. It is a summary of how risky the earnings look to a buyer. Everything that makes the earnings more likely to continue after you leave pushes it up.

What moves the multiple

These push it up:

• Revenue that recurs or is under contract, rather than won again every month
• A spread of customers, with no single one much above ten or fifteen percent of revenue
• A business that runs without you, with trained staff and written procedures
• Financial records that are clean and reconcile to the tax returns
• A transferable lease with options left on it
• Three years of steady or growing revenue

And these pull it down, sometimes sharply:

• An owner who is the business, holding all the relationships and knowing things nobody has written down
• One customer accounting for a large share of revenue
• Declining revenue, particularly if the trend is recent
• Cash receipts that cannot be proved from the records, which buyers simply will not pay for however real they are
• A short lease, or a landlord who will not assign it
• Equipment at the end of its life, or maintenance that has been deferred
• Licenses or approvals that do not transfer with the sale

Owner dependence is the one worth taking seriously well before you sell. Two otherwise identical businesses can be a full turn apart on the multiple purely because one of them keeps running when the owner takes a month off. That is often worth more than any price negotiation you will have, and it takes a year or two to fix.

A worked example

Take a heating and cooling contractor, nine years established, six employees. The tax return shows net profit of $95,000. Working through the add-backs:

• Owner's salary: $70,000
• Payroll taxes on that salary: $6,000
• Vehicle and phone used personally: $9,000
• Interest on an equipment loan: $8,000
• Depreciation: $22,000
• One-off legal costs from a dispute now settled: $12,000

That gives an SDE of $222,000. Now the risk picture. No customer is above eight percent of revenue, which is good. A lead technician runs the jobs day to day, which is good. But the owner does all the selling, which is not. Revenue has grown modestly for three years. That profile lands around three times, so roughly $666,000.

What the price includes matters just as much as the multiple, and it is where deals get argued. A price like this normally includes the equipment, vehicles and fixtures, plus a normal level of inventory. It normally excludes cash in the bank and money owed by customers, and the business is expected to transfer with no debt attached. Agree all of that in writing early, because "three times SDE" means very different things depending on what comes with it.

Other methods, and when they matter

Asset-based valuation

Adds up what the business owns and subtracts what it owes. For a profitable business this is a floor rather than a valuation, since a going concern is worth more than its parts. It becomes the main method when a business is asset-heavy or is not making money.

Discounted cash flow

Projects future cash and discounts it back to today. It is standard for larger businesses with predictable cash flow, but it is extremely sensitive to the growth and discount assumptions you feed it, and small business buyers rarely find it persuasive.

Industry rules of thumb

A multiple of revenue, a figure per truck, per seat, per bed. Useful as a sanity check on a number you got another way, but not a valuation. Two businesses with identical revenue can be worth very different amounts, and the rule of thumb cannot see the difference.

Comparable sales

What similar businesses in your industry and region actually sold for, not what they were listed at. The most persuasive evidence there is, and the hardest to get hold of, because completed transactions are private. Brokers subscribe to databases of closed deals, which is a large part of why their opinion of value carries weight with buyers and lenders.

Mistakes that cost sellers money

Valuing on revenue

Buyers buy earnings. Revenue only tells them how big the operation is.

Mixing up SDE and EBITDA multiples

Worth re-checking before you publish a price. It is the error that makes a listing look unserious to anyone experienced.

Add-backs you cannot document

They will not survive due diligence, and they damage trust in every other figure you have presented.

Pricing off your best year

Buyers look at the trend, and they weight the most recent twelve months most heavily.

Charging for potential

If the upside needs the buyer's capital and effort to realize, the buyer is not going to pay you for it today.

Ignoring what transfers

Goodwill tied to you personally, rather than to the business, does not come with the sale.

When to bring in a professional

A formal appraisal from a credentialed appraiser is worth paying for when the number has to stand up to someone else's scrutiny: a partner buyout, a divorce, an estate, a dispute heading for court, or certain lender requirements. Those reports are detailed, they take weeks, and they cost accordingly.

For an ordinary sale, that is usually more than you need. A business broker who works in your industry and region can give you an opinion of value grounded in deals that actually closed, and will normally do it as part of an initial conversation about listing. Even if you go on to sell the business yourself, that conversation is worth having, because a price set from real comparable sales is far harder for a buyer to argue down than one you calculated alone.

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Common questions

Can I value my business myself?

For setting an asking price, yes. Work out your SDE carefully, apply a multiple appropriate to your industry and risk profile, and sanity check it against listings for similar businesses. What you cannot do alone is see the closed-transaction data, so it is worth testing your figure against someone who can.

Does the asking price include inventory?

Usually a normal working level of inventory is included, with any unusual excess treated separately at cost. Say explicitly which you mean in the listing. This is one of the most common causes of a deal souring late.

Do I need audited financial statements?

Very rarely for a small business. What you do need is three years of tax returns, profit and loss statements that reconcile to them, and documentation for every add-back you are claiming. Consistency between those matters far more than the formality of the reporting.

Will a buyer accept my asking price?

Expect negotiation, and expect the structure to matter as much as the headline figure. An offer with more cash at closing is worth more than a larger offer loaded with earnout conditions that depend on performance after you have gone.

How long does it take to sell?

Six to twelve months is typical for a small business, and longer if the price is ahead of the earnings. Pricing realistically at the start is the single biggest factor in how quickly you close.

Next steps

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