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Practical valuation guide for small businesses

November 24, 2024

Practical valuation guide for small businesses

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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:

  1. 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.

  2. 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:

  1. Market conditions: External factors that affect all businesses in your industry

  2. 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:

  1. Predictable revenue: Long-term maintenance contracts vs. project-based work

  2. Customer diversity: 200+ buildings vs. 3 main contractors

  3. Economic protection: Buildings need maintenance in any economy

  4. 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:

  1. Identifying all valuable assets (equipment, vehicles, real estate, inventory)

  2. Determining their fair market value (not book value)

  3. 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:

  1. 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

  2. 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.