How to Value a Small Business for Sale

How to Value a Small Business for Sale

If you are considering selling your company, there’s nothing more important than learning how to value a small business for sale. It’s critical to understand the factors that drive a business valuation, and it’s essential to recognize that only about 20% of small businesses ever sell. Why such a low percentage? There are really two primary reasons: 1) business owners’ failure to plan for a sale; and 2) unrealistic asking prices for businesses. Both are within your control. So congratulations for taking the time to educate yourself about how to value a business for sale.

To value a small business, the first step is to determine your seller’s discretionary earnings (SDE). Then SDE is multiplied by an appropriate multiple to arrive the estimated value of the business. Let’s provide an example.

Example - Assumptions to Value a Small Business for Sale

Let’s assume the tax return of a small business shows $850,000 in revenues with taxable income of $50,000. Included as expenses on the tax return are interest expense of $15,000, depreciation of $10,000 and amortization of $5,000. The Officer’s Compensation line shows $150,000. In addition, the tax return shows $20,000 on the Pension and Profit Sharing line for a 401K matching deposit (of which $5,000 was deposited into the plan for the owner’s benefit). Also, the company’s insurance expense includes $10,000 for the owner’s health insurance. And finally, the owner charged $5,000 of gasoline and car repairs for his personal vehicle to the company credit card but only uses the car for his daily commute. In other words, that $5,000 of car expenses are not really necessary expenses of the business, but they are included as expenses in the tax return.

At first blush, you might think the company is valued based on its $50,000 in taxable income. But that far understates the discretionary earnings of the business. In computing SDE, the goal is to “recast” or “normalize” the earnings so it reflects the total “owner benefits” available to a buyer of the business.

Calculating Sellers Discretionary Earnings

Based on the assumptions in the prior paragraph, here is how to calculate seller’s discretionary earnings to value that small business for sale.

How to Value the Small Business for Sale

Now that we’ve recast (or normalized) the tax return results to arrive at seller’s discretionary earnings, we need to multiply by the appropriate multiple. At this level of SDE, the appropriate multiple is about 3.0x, so the estimated value of the small service business is $750,000 ($250,000 x 3.0). To view a chart of earnings multiples based on SDE, read Newsletter Issue #6 - How Small Businesses Are Valued Based on Seller's Discretionary Earnings (SDE).

This is a fairly simplistic example of how to value a small business for sale. For example, there are many other types of add backs or even negative adjustments to SDE that must be considered. This website devotes a substantial amount of content to business valuation issues and many of the articles explore in greater depth more complex aspects of how to value a business. To learn more, read the six newsletter articles mentioned below.

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ATTENTION: Business Owners & Prospective Sellers!

For a more in-depth explanation of how to value a business, check out these 6 articles featured in the How to Sell a Business Newsletter Series.  There may be nothing more important to a successful sale than your full comprehension as to what your business is worth and how your company value will be determined.  Following is a brief description of the 6 articles:

Newsletter Issue #6 - How Small Businesses Are Valued Based on Seller's Discretionary Earnings - Explains SDE and contains a chart of SDE multiples by business size.

Newsletter Issue #7 - SDE vs. EBITDA vs. Adjusted EBITDA Leads to Multiples Confusion - Explains the importance of specificity in describing “earnings” to avoid confusion when choosing a valuation multiple.

Newsletter Issue #8 - An Example of SDE vs. EBITDA vs. Adjusted EBITDA - Explains by example how one company with the same valuation has 3 different multiples.  Hint: the multiple depends on the measure of earnings.

Newsletter Issue #9 - A Seller's Discretionary Earnings (SDE) Worksheet - Contains an example of an SDE worksheet with 29 add backs.

Newsletter Issue #10 - SDE and Business Valuation Variations amongst Sellers, Buyers and Lenders - Explains how a seller, a buyer and a lender arrive at different business valuation conclusions based on their acceptance or rejection of the 29 add backs in Newsletter Issue #9.

Newsletter Issue #11 - The Importance of Setting a Realistic Offering Price - Explains why it is counter-productive to overprice a business for sale.