Business Valuation Basics: How Small Businesses Are Valued

Ask ten owners what their business is worth and most will give a number they heard from a competitor, a broker, or a rule of thumb at an industry conference. Ask them how they arrived at it and the answers get vague. For most owners the business is the largest asset on their personal balance sheet, larger than their home and their retirement accounts combined, and it is also the one they understand least as an investment. That is the case for learning business valuation basics long before a sale is on the table.

Valuation matters at more moments than owners expect. It sets the price in a sale, but it also sets the buyout figure in a buy-sell agreement, the amount of key person insurance to carry, the value of a gift to a child, the number in a divorce settlement, and the estate tax exposure if an owner dies. It also tells you whether your retirement plan works, since a plan that assumes the business will sell for $5 million looks very different if the honest number is $2 million.

This article explains how appraisers and buyers actually value a small business, what the multiples mean, what moves them up or down, and when a formal appraisal is worth paying for. It is educational, not individualized advice, and it is not a substitute for a credentialed appraiser when the number has legal or tax consequences.

The Three Approaches to Business Valuation

Professional appraisers work from three broad approaches, and the IRS's own valuation guidelines expect all three to be considered. Each approach answers a different question, and the weight given to each depends on the type of business.

The Income Approach

The income approach asks what the future cash flows of the business are worth today. The two main versions are capitalization of earnings, which divides a single normalized earnings figure by a capitalization rate, and discounted cash flow, which projects several years of cash flow and discounts each year back to the present. The discount rate reflects the risk of the business: a stable company with contracts and a management team might be valued with a discount rate in the high teens, while a young owner-dependent business might carry a rate above 25 percent. Small changes in the rate produce large changes in value, which is why the assumptions matter more than the arithmetic.

The Market Approach

The market approach asks what similar businesses have sold for. Appraisers pull transaction data from private databases that track sales of small and mid-sized companies by industry, then apply the resulting multiples to the subject company's revenue or earnings. This is the approach most buyers and brokers use informally when they say a business in your industry sells for three times earnings. The quality of the comparables is everything. A database multiple is an average across companies of different sizes, growth rates, and quality, and the subject company may deserve to be above or below it.

The Asset Approach

The asset approach values the business as the fair market value of its assets minus its liabilities. It sets a floor for most operating companies and is the primary method for holding companies, asset-heavy businesses with weak earnings, and businesses being liquidated. For a profitable service business with few hard assets, the asset approach produces a number far below what a buyer would pay, because it ignores goodwill. When an appraiser relies on the asset approach for a going concern, it usually means the earnings do not support anything higher.

Earnings Multiples: SDE and EBITDA

For most owners, valuation comes down to a multiple of earnings. The earnings figure and the multiple both need definition, because the same business can be described with very different numbers depending on which measure is used.

Seller's Discretionary Earnings

Seller's discretionary earnings, or SDE, is the measure used for owner-operated businesses, roughly those with less than $1 million to $2 million in earnings. SDE starts with pre-tax profit and adds back the owner's salary and benefits, interest, depreciation, amortization, and any personal or one-time expenses run through the business: the family car, the country club, a one-time lawsuit, a spouse on payroll who does not work there. The result is the total economic benefit one owner-operator receives from the business. Small businesses typically trade at 2 to 4 times SDE, with the low end for businesses that depend entirely on the owner and the high end for those with staff, systems, and growth.

EBITDA

Earnings before interest, taxes, depreciation, and amortization is the measure used for larger businesses that a buyer would run with a hired manager. The difference from SDE is that a market-rate salary for a general manager is subtracted, because the buyer will have to pay one. A business with $1.5 million of SDE and a $250,000 manager replacement cost has $1.25 million of adjusted EBITDA. Lower middle-market companies commonly trade at 4 to 7 times EBITDA, and companies above $5 million of EBITDA can command higher multiples, particularly from private equity buyers. Investopedia's EBITDA explainer covers the accounting detail.

Normalizing the Numbers

Buyers and appraisers recast the financial statements before applying any multiple. They remove non-recurring items, adjust rent to market if the owner also owns the building, adjust the owner's salary to market, and look for revenue or expenses that will not continue. An owner who has minimized taxable income for years through aggressive deductions will find that the same deductions now reduce the valuation unless they can be documented and added back. Clean books that show true profitability are worth more than a low tax bill in the years before a sale.

What Raises the Business Valuation Multiple

Two businesses with identical earnings can sell for very different prices. The multiple captures the buyer's judgment about how likely those earnings are to continue after the owner leaves, and how easily they can grow. These are the factors that consistently push the multiple up.

• Recurring or contracted revenue. Subscriptions, service contracts, and repeat customers are worth more than project-based revenue that must be re-won every year.
• Owner independence. A business that runs for a month while the owner is on vacation has a management layer. A business where every decision and every client relationship runs through the owner is buying the owner, and buyers discount for the risk that the owner's departure takes the customers along.
• Customer diversification. If any single customer represents more than 10 to 15 percent of revenue, buyers see concentration risk. A top customer above 25 percent can cut the multiple sharply.
• Clean, reviewed financial statements. Three years of accountant-reviewed or audited statements, consistent accounting methods, and tax returns that match the books reduce diligence risk.
• Documented processes and systems. Written procedures, a functioning CRM, a real employee handbook, and modern software make the business transferable.
• Growth with a credible path. Steady revenue growth, a pipeline, and a market with room to expand all support a higher multiple than flat results.
• Strong margins relative to the industry. Margins above peers suggest pricing power or efficiency a buyer can maintain.
• Key employees under agreement. Non-compete or retention agreements with the people who matter reduce the risk of losing them at closing.

What Lowers It

The mirror image applies. Heavy owner dependence, customer concentration, messy books, deferred maintenance on equipment, litigation, an expiring lease on a location that matters, a workforce that could walk, and an industry in structural decline all push the multiple down. So does a lack of a management bench, which is one reason we encourage owners to think about succession years before an exit.

Different Purposes, Different Values

The standard of value changes with the purpose, and owners are often surprised that the same business can legitimately carry different numbers at the same time.

• Fair market value is the hypothetical price between a willing buyer and a willing seller, neither under compulsion, both with reasonable knowledge. It is the standard for gift and estate tax and for most buy-sell agreements.
• Investment value is what a specific buyer would pay given their own synergies. A competitor who can cut overhead may pay more than fair market value. This is the number that matters in an actual sale.
• Fair value is a legal standard used in shareholder disputes and some divorce cases, and it often excludes the discounts applied under fair market value.
• Liquidation value is what the assets would fetch if sold piecemeal, relevant only when the business is not viable as a going concern.

Discounts for Minority Interests and Lack of Marketability

When a partial interest is valued, appraisers typically apply discounts. A minority interest that cannot control distributions or force a sale is worth less per share than a controlling interest, and an interest in a private company that cannot be sold easily is worth less than a liquid one. Combined discounts of 20 to 40 percent are common. These discounts are the reason gifting minority interests to family members or trusts is a well-established estate planning technique, and the IRS scrutinizes them closely. An appraisal used for a gift must be a qualified appraisal that meets IRS standards, and it should be coordinated with your estate planning attorney and CPA.

When You Need a Formal Appraisal

A broker's opinion of value or a back-of-envelope multiple is fine for planning conversations. A formal appraisal from a credentialed appraiser, holding an ABV, ASA, or CVA designation, is needed when the number has legal or tax consequences.

A full appraisal typically costs several thousand dollars and produces a written report documenting methods, comparables, adjustments, and the conclusion. A narrower calculation engagement costs less and is often enough for planning. Update it every two to three years for a buy-sell agreement. The Small Business Administration also publishes guidance for owners preparing to sell.

• Gifting or selling an interest to a family member, where the IRS can challenge the value
• Funding a buy-sell agreement or updating the value it uses
• An estate settlement, where the value sets the basis for heirs and any estate tax
• A divorce, where the business is a marital asset and both sides may hire appraisers
• Bringing in a partner or issuing equity to key employees
• An ESOP transaction, where an independent appraisal is required by law
• A shareholder dispute or a buyout under an operating agreement

Using the Valuation in Your Personal Plan

A valuation is not just a number for a transaction. It is an input to nearly every part of an owner's financial plan. If the business is worth $3 million and represents 70 percent of your net worth, you are heavily concentrated in a single illiquid asset that depends on your health and effort. That shapes how much liquidity you keep outside the business, how much life and disability insurance you carry, whether a buy-sell agreement is properly funded, and how aggressively your investment portfolio should be positioned.

It also anchors your retirement plan. Owners tend to assume the sale will fund retirement, but sales take longer than expected, prices come in lower than hoped, and taxes take a large bite. Our article on taxes when selling a business shows how much of the headline number actually reaches your account. Working from a realistic after-tax value, and planning as if the business might sell for less, is the conservative approach we take in our business owner planning.

A business is worth what a buyer will pay for its future earnings, adjusted for the risk that those earnings disappear when the owner walks out. Understanding the multiple, and the factors that move it, gives you years to raise the number before anyone is negotiating. It also gives you an honest figure to plan around today. Attend Wealth helps owners integrate a realistic business value into their retirement, insurance, and estate planning, coordinating with appraisers, CPAs, and outside estate attorneys. Our advisory services are held to a fiduciary standard, and this article is educational rather than individualized advice.

Tony Colunga · Founder, Attend Wealth

Tony leads Attend Wealth, a fee-based wealth management firm in Atlanta serving professionals, families, physicians, and business owners. Advisory services are held to a fiduciary standard. More about Attend