How Small Businesses Are Valued

How Small Businesses Are Valued

Almost every business owner ponders at some time: what is my business worth? Maybe it is in preparation to sell the business, raise capital, or just because you are curious. And you may think the formula and the answer is fairly simple, but unfortunately, that Is not always the case. 

Depending on the purpose of the valuation, businesses are valued in different ways. These different methods include the asset method, income method, and market method. 

In this post, we will focus on the market method. This method is the most accurate way to value businesses for the purpose of selling a business to a third party in the main street or lower middle market for M&A transactions. 


The Market Method
The market method is a comparable sale method, where a valuation expert takes data from previous sales of businesses that are similar in size and quality and follows these steps:

1.  A comparable sales report is created to help determine what multiple of earnings a business would sell for.

2.     This multiple is then applied to one of the below earnings numbers: 

a.     SDE (seller’s discretionary earnings) 

b.     Or, EBITDA (earnings before interest, taxes, depreciation and amortization) 

The main difference between the two numbers is that SDE includes EBITDA plus one owner’s salary and benefits (you typically see EBITDA used in larger valuations or transactions purchased by private equity firms).  

3.  Once you have the multiple from the comparable sales report and the earnings number, it is a simple math formula: SDE x Determined Multiple = The Value of Your Company 

Most companies sell for 2-6 times SDE. If you look at all business sales under $1 million for the last 10 years, the average multiple of SDE is 2.2 times but sometimes the multiple is not as high as the seller wants or thinks it should be.

Some clients tell us, if the multiple is only 2 times then they should just keep the company. And the truth is that if the only reason you are considering selling is for financial benefit, then yes, sometimes it is better to keep the business. 

But most business owners do not sell just for financial benefit, there is another life event that is the main cause for sale: retirement, health, relocation, change of passions, or desire to try something new.   


Increasing Your Business Valuation
The next question you might as is: how do I increase my multiplier? The simple answer: increase the value of your business. There are also plateaus in business valuation, the larger the SDE becomes the larger the multiple is as well. Depending on industry, you could see a multiple increase once your earnings become greater than $500,000 or $1 million. 

The best way to increase the valuation of a company is to focus on one of two areas: the quantity of earnings or the quality of earnings. Quantity is straightforward, increase the amount of SDE and the valuation goes up!

The more intricate work comes with focus on the quality of earnings. Buyers want diversified and recurring revenue streams, and stable employees. For example, most buyers want to be a business owner versus an operator (also known as absentee ownership). Buyers also value certain business attributions higher than others. If you are able to achieve this, it can also increase the multiple of the business which increases the valuation.  

Sometimes, it is not possible in increase the quantity of your earnings for whatever reason, meaning you will need to focus on the more complicated option, quality of earnings. Often, knowing where to start can be the hardest part but we can give you insight and actionable steps to take. Increasing the value of your business can be easier than you’d think. This is the area that we focus on in our Prep to Sell program.


This is a complex topic and if you would like to learn more about the valuation process or how you can increase the valuation of your business, please reach out!


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