November 24, 2024
Practical valuation guide for small businesses
For most business owners, their company represents their single largest asset – often accounting for 80-90% of their net worth. Yet unlike their home value (which they can check on Zillow) or their stock portfolio (which they can monitor daily), most owners don't have a clear picture of what their business is actually worth.
Regardless of where you are in your entrepreneurial journey, not knowing your business's true value can have costly consequences:
If you plan on selling your business in the future:
If your business value falls short of your financial and/or retirement goals, you'll have time to make operational improvements to bridge that gap.
If you are looking to sell your business today:
It prevents costly mistakes during negotiations. Without a solid understanding of your business's worth, you risk either accepting a lowball offer that leaves money on the table, or rejecting a fair offer because it didn't match your expectations.
Many owners find the valuation process daunting, but it doesn’t have to be. In this article, we will teach you everything you need to know about valuing your business, and provide actionable advice on what you can do today to increase its value.
In this article you'll learn:
Valuation Fundamentals: How buyers think about business value and the basic formula they use (Profitability × Multiple)
Understanding Business Profitability: How to calculate your true profitability using EBITDA or SDE, including common adjustments and real examples
Valuation Multiples: What drives your multiple higher or lower, from both market conditions and company-specific factors
Alternative Valuation Methods: When and why asset-based or revenue-based approaches might be more appropriate
Practical Steps: How to value your own business and what to watch out for in the process
By investing just a few minutes, you'll learn everything you need to know about how businesses are valued and what you can do to maximize your business's worth.
Understanding Valuation Fundamentals
No matter how much blood, sweat, and tears you've put into building your business, its value ultimately comes down to what buyers are willing to pay for it. To maximize your business's value, you need to understand how buyers think about valuation.
Buyers typically determine a business's value using a straightforward formula:
Business Value = Current Profitability × Valuation Multiple
Let's break this down:
Current profitability measures how much money your business makes today (typically expressed as EBITDA or SDE, which we'll explain below)
Valuation Multiple reflects how risky buyers perceive your business to be – the lower the risk, the higher the multiple
Understanding these components is crucial because it shows you exactly where to focus your efforts to increase your business's value.
Let's dive into each element to see how this works in practice.
Business Profitability: EBITDA vs SDE
Not sure what your business's true profitability is? You're not alone. Most business owners know their top-line revenue numbers but have little understanding of their true bottom line. While sales are important, buyers focus primarily on how much money the business generates after all expenses are paid.
To standardize this analysis, the industry uses two key profitability metrics, depending on the size of your business:
For businesses with over $5 million in sales: EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization)
For businesses with under $5 million in sales: SDE (Seller's Discretionary Earnings)
Let's examine each metric to understand which applies to your business and how to calculate it.
Understanding EBITDA
EBITDA is the most common metric that buyers will use to assess your company’s profitability. This metric excludes interest expense, taxes, and depreciation from your net profit to reveal your business's true operational performance:
Excluded cost | Explanation | ||
---|---|---|---|
Interest expense | Why excluded: Separates true operational performance from financing choices made by the owner Example: Two identical businesses could have vastly different interest expenses just because one owner borrowed money while another used savings | ||
Taxes | Why excluded: These vary by business structure (LLC vs. S-Corp) and availability of tax losses, not business performance Example: If a business is acquired by a company with large tax losses, the business will pay no taxes until those losses run out | ||
Depreciation & Amortization | Why excluded: These are accounting entries, not actual cash expenses Example: If you buy a $1 million machine with a 10-year useful life, your income statement shows a $100K expense annually for 10 years, even though the cash was paid only once |
EBIDTA Example Calculation
Let's consider an example, starting with $450,000 of net profit:
Net Income | $450,000 | ||
---|---|---|---|
Interest | $75,000 | ||
Taxes | $150,000 | ||
Depreciation | $100,000 | ||
Amortization | $25,000 | ||
EBIDTA | $800,000 |
💡 Key insight: your business is actually generating $800,000 in true operational profit - almost double the $450,000 shown on your tax return! Using net income alone would severely undervalue your business.
Understanding SDE
For smaller businesses, EBITDA alone doesn't usually tell the full story because business owners often:
Pay themselves below-market salaries to minimize payroll taxes
Run personal expenses through the business (vehicles, health insurance, travel)
May employ family members at varying compensation levels
To be clear - these practices are perfectly legal and common - but they can significantly understate the true profitability of your business to a prospective buyer.
SDE solves this by starting with EBITDA and adding back owner-related expenses to show the true earning potential available to a new owner.
SDE Calculation Example
Starting with EBITDA of $300,000, we add back:
EBITDA | $300,000 | Explanation | |||
---|---|---|---|---|---|
Owner's Salary | +$80,000 | Owner earns $80K salary, significantly below market | |||
Market rate CEO salary | -$120,000 | Cost of hiring a professional CEO (since the new owner may not operate the business themselves) | |||
Personal vehicle expenses | +$45,000 | Owner paid for a new car with their business profits | |||
Family health insurance | +$10,000 | Owner covers his family’s insurance with business profits | |||
Spouse salary | +$80,000 | Owner pays their spouse $80K to lower company profits | |||
Personal travel and perks | +$10,000 | Owner pays for family vacation with business profits | |||
SDE | $405,000 |
As you can see, the true business’s profitability is 30%+ higher than what EBITDA alone would tell us - which directly translates into higher valuation as seen by a buyer.
Why this matters:
Whether using EBITDA or SDE, the key takeaway is clear: your business is likely more profitable than what shows up on your tax returns. Understanding these adjustments is crucial because they directly impact your business's value - every dollar of adjusted profit typically translates into several dollars of business value through the valuation multiple (which we'll discuss in the next section).
How to Adjust Your Earnings
Regardless of whether you use EBITDA or SDE, you should also identify any one-time or non-recurring expenses that affected your profit. These expenses don't reflect your business's true ongoing operational performance and should be added back:
Common examples include:
Office relocation costs
Legal fees from a one-time lawsuit
Costs from implementing a new software system
One-time consulting projects
Losses from discontinued product lines
COVID-related expenses (PPE, workplace modifications)
For example, if your business spent $50,000 moving to a new location last year, this expense should be added back to your EBITDA or SDE since it won't occur again and doesn't reflect your normal operations.
Valuation Multipliers 101
Key Valuation Drivers
Think of a valuation multiple like a risk score - it reflects how risky buyers perceive your business to be. The safer the business, the higher the multiple, and therefore, the more valuable your business becomes. For example, a business generating $1M in SDE might be worth $3M (3x multiple) or $6M (6x multiple) depending on its risk profile.
The multiple is primarily influenced by two factors:
Market conditions: External factors that affect all businesses in your industry
Company-specific characteristics: These are factors specific to your business that you can control and improve
Market factors
Here are some of the main market factors that will affect your business’s valuation multiplier:
Factor | Description | ||
---|---|---|---|
Economic Environment | Higher interest rates and uncertain economic conditions typically reduce multiples as buyers become more conservative | ||
Industry Growth | Growing industries command premium multiples, while declining industries or those facing technological disruption see reduced buyer interest and lower valuations | ||
Buyer Demand | Strong competition among buyers (both strategic and financial) drives up multiples; limited buyer interest reduces multiples | ||
Supply of Business | Large number of businesses for sale in an industry typically reduces multiples due to increased buyer options | ||
Recent Similar Transactions | Recent sales of similar businesses set market expectations for valuation multiples | ||
Access to Capital | Easy access to acquisition financing (bank loans, PE capital) increases buyer demand and multiples | ||
Regulatory Environment | Increased regulation or regulatory uncertainty typically reduces multiples due to higher compliance costs and risks |
Company-specific factors
Factor | Questions | ||
---|---|---|---|
Business Size | Larger companies are deemed to be less risky and therefore attract higher multiples | ||
Operational Stability | Have your revenues been stable and/or growing over the last 3-5 years, or have they been volatile/trending down? | ||
Revenue Predictability | Do you have recurring revenues or long-term customer contracts or is your revenue mostly project-based and lumpy? | ||
Economic Cycle Dependence | Do you provide an essential recurring service (i.e., emergency repair and maintenance) or do you engage in new construction? | ||
Customer Concentration | Do your five biggest customers contribute to 10% of your total revenue, or 75%? | ||
Owner Dependence | Are you wearing 10 different hats in your business or do you have a capable management team in place allowing the business to run largely on autopilot? | ||
Systems and Processes | Do you have strong documentation of internal operations? Are your financial records clean and organized? | ||
Track Record | Have you been in operation for four generations? Did you start the business three years ago? |
Real-World Case Study
Understanding these factors is best illustrated through a real example.
Let’s say that you own a a business in the plumbing industry, which typically attracts valuation multipliers of 3-6x - but which one is most appropriate for your business?
Let's look at two plumbing companies that generate the same profit but have very different values.
Plumbing Company A | Plumbing Company B | ||||
---|---|---|---|---|---|
Revenue | $10M | $20M | |||
EBIDTA | $2M | $2M | |||
Services | 100% commercial service & maintenance | 100% commercial new construction | |||
Business Model | • Annual maintenance contracts with office buildings • 24/7 emergency repair services • 200+ commercial buildings under contract • Largest customer is 5% of revenue | • Project-based work for general contractors • Competitive bid process • 3 contractors represent 70% of revenue • Highly dependent on new building | |||
Multiplier | 6.5x | 2.75x | |||
Value | $13M | $5.5M |
Why the huge value gap?
The service business is worth more than twice as much because:
Predictable revenue: Long-term maintenance contracts vs. project-based work
Customer diversity: 200+ buildings vs. 3 main contractors
Economic protection: Buildings need maintenance in any economy
Less competition: Harder to displace an existing service provider
Other Valuation Approaches
While the earnings-based approach we've discussed is most common, there are situations where other valuation methods might be more appropriate. Let's look at two alternative approaches below.
Asset-Based Valuation
Asset-based valuation is typically used when:
The business is unprofitable or marginally profitable
Most of the value comes from physical assets (equipment, real estate, inventory)
The business is in distress or considering liquidation
In these cases, the business value is calculated by:
Identifying all valuable assets (equipment, vehicles, real estate, inventory)
Determining their fair market value (not book value)
Subtracting any outstanding debts or liabilities
For example, a construction company might be struggling with profitability, but own $2M in equipment and a $1M workshop. Even if the business isn't generating much profit, these assets provide a baseline value for the business.
Revenue-Based Valuation
Revenue-based valuation is common in:
Software companies with recurring revenue
High-growth technology businesses
Companies with significant revenue but not yet profitable
These businesses are often valued as a multiple of their Annual Recurring Revenue (ARR), and not their EBITDA or SDE.
⚠️ Important note: This approach is typically reserved for larger software companies ($10M+ in revenue). Smaller software businesses are still often valued based on EBITDA or SDE, as buyers want to see proven profitability.
4 Steps to Value Your Business
After understanding how buyers think about business value, here are the key steps to determine what your business might be worth:
1. Calculate Your True Profitability
Determine whether EBITDA or SDE is appropriate for your business size
Identify all necessary adjustments to show true operational performance
Calculate adjusted profitability for the last 3 years
2. Research Industry Valuation Multiples
Identify recent sales of similar businesses
Understand typical valuation ranges for your industry
Consider current market conditions and trends
3. Make Company-Specific Adjustments
Evaluate your business against the operational characteristics we discussed
Adjust the multiple based on your business's strengths and weaknesses
Consider how market conditions might impact your specific situation
4. Calculate Valuation Range
Apply the adjusted multiple to your profitability metric
Consider providing a range rather than a single number
Document your assumptions and adjustments
Important valuation considerations
While these steps seem straightforward, getting to an accurate valuation can be challenging for several reasons:
Financial Complexity: Understanding true profitability can be difficult, especially with numerous adjustments or unclear financial records
Limited Market Data: Most business sales are private transactions, making it hard to find reliable data on comparable sales
Subjective Adjustments: Without deep market knowledge, it's challenging to know how much each factor should impact your multiple
Best Practices for Getting It Right
Given these challenges, consider taking these steps:
Engage Your CPA
Have them review and validate your financial statements
Get professional calculation of adjusted EBITDA or SDE for the past 3 years
Ensure all adjustments are properly documented
Consult an experienced M&A Advisor
Access their proprietary transaction database
Leverage their understanding of how buyers evaluate businesses in your industry
Get expert guidance on company-specific adjustments
⚠️ Warning: Be cautious of free online valuation calculators. While tempting, these tools can produce misleading values (both too high and too low) because they:
Often use oversimplified formulas
Rarely reflect current market conditions
Don't consider company-specific factors
Remember: Understanding your business's value is crucial for planning your exit strategy. While this guide gives you a framework for thinking about value, getting professional help can be the difference between leaving money on the table and maximizing your business's worth.
Maximizing Your Business’s Potential
Understanding your business's true value isn't just about preparing for a sale - it's about making better decisions for your business today.
Summary:
Understanding Profitability helps you:
Identify your key revenue drivers and cost centers
Make data-driven decisions about where to invest
Set realistic growth targets based on true performance
Understanding Value Drivers shows you:
Which operational improvements will have the biggest impact on your business value
How to build a more sustainable business that's attractive to buyers
Where to focus your efforts to maximize value for your eventual exit
Next Steps
Whether you’re just starting to explore your exit options or ready to meet potential buyers, we’re here to help you guide your path forward.
Schedule a free confidential consultation with an OffDeal M&A advisor to:
Understand your business’s current market value
Explore actionable steps you can take to increase the value of your business today
Learn about the current buyer demand for your business
Schedule call with OffDeal M&A Expert
Preview potential buyers, for free
OffDeal leverages advanced technology and expertise to help small business owners achieve the same quality of M&A service previously reserved for large corporations. Our mission is to ensure every business owner has the opportunity to maximize their value when they're ready to sell.