Geoff CuddHas your small business taken off, but now you’re ready to cash in on your hard work and sell it?
Congratulations! This is a huge step! And though exciting, it can be scary to know how much you should sell it for.
Here’s a step-by-step guide on how to calculate the best possible price to sell your small business.
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Key Takeaways
- Seller’s Discretionary Earnings (SDE) and Earnings before interest, taxes, depreciation, and amortization (EBITDA) are key valuation metrics in valuing your small business for sale
- To value your small business, you should gather essential documents, establish net income, look at multiples, research the market, and determine the growth rate
- The most common valuation methods are market-based, asset-based, or income-based
Understanding Key Valuation Metrics: SDE & EBITDA
First, let’s get on the same page with common vocabulary.
The two biggest terms you’ll need to know about are Seller’s Discretionary Earnings (SDE) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
Seller's Discretionary Earnings (SDE)
Seller’s Discretionary Earnings (SDE for short) represents the total financial amount an owner makes on the business in a year. This includes the business's net profit, plus any owner’s salary, perks, discretionary expenses, and non-cash expenses like depreciation.
The SDE of your business is key in valuing your business for sale, as it’s the Big Number that shows how profitable your business is and how much money you have made off of it.
When considering valuation, this number is usually multiplied by an industry-specific number (2-5). to estimate the business's overall value.
For example, if a business has an SDE of $100,000 and the industry multiple is 3, the business might be valued at $300,000.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
Another number important to consider is the EBITDA, which is used to assess a business's operating performance by stripping out non-operational expenses.
Unlike SDE, which includes the owner's salary and discretionary expenses, EBITDA focuses solely on the business’s profitability from operations.
This makes it especially useful when comparing businesses of different sizes or ones in industries where owners don't manage day-to-day operations.
Think of it as the value of a business in an isolated environment, in a vacuum where other stuff isn’t factored in. It shows how profitable the business is, independent of its financing, tax environment, and non-cash accounting factors.
Steps to Take to Value a Small Business
Now that we’re speaking the same language, let’s break it down step by step.
If these steps seems too early, check out our guide on how to prepare for a sale >>
1. Organize Your Essential Documents & Assets
The first step is to get your house in order. This means organizing all essential documents and assets, including financial statements, tax returns, asset lists, contracts, and any intellectual property documents.
These documents are crucial for accurate valuation and to provide potential buyers with a clear understanding of your business's financial health and assets.
2. Establish Net Income
Next, calculate your business’s net income, a key figure that potential buyers will use to assess how profitable and valuable your small business is.
You can get this number by subtracting all operating expenses, taxes, and costs from your total revenue.
3. Look at Multiples
Looking at multiples is a good way to see how much another similar small business in your industry has sold for recently to give you a rough estimate of how much yours should sell for as well.
The simplified explanation of how to do this is to take the sales price of a recently sold, comparable company and divide it by the company’s total sales, EBIT (Earnings Before Interest and Taxes), or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This will give you the multiple. Then, apply this multiple to your own company's sales, EBIT, or EBITDA to estimate your business's value.
Sales Price of Recently Sold Comparable Company / Company Total Sales = Multiple to Use
this is a very very simplified formula
You’ll need to research your industry to determine an appropriate multiple and consider consulting with a business broker or valuation expert to get a more accurate figure.
4. Research Your Market
Next, research recent sales of similar businesses in your industry and area.
Look for businesses similar in size, customer base, and revenue to see what they sell for. This helps you gauge what buyers are willing to pay and ensures your valuation aligns with current market conditions.
You should also consider trends within your industry—like technological advancements, consumer behavior shifts, or economic factors—that could have an impact on the valuation.
5. Determine Growth Rate
Lastly, analyze your revenue and profit trends over the past few years to figure out your historical growth rate.
Then, forecast future growth by considering factors like market expansion opportunities, new product lines, or untapped customer segments.
A higher growth rate can lead to a higher valuation multiple since it shows the business has good potential to increase earnings in the future. This can make your business look better to potential buyers.
Valuation Methods
There are a few different valuation methods you can use to show your business’s worth to potential buyers.
Here are the three best valuation methods:
1. Market-Based Valuation
The first and most popular valuation method is market-based valuation.
In market-based valuation, the value of the target company is estimated by looking at what investors are willing to pay for similar companies.
For example, if other companies are worth 10 times what they earn in a year, and your company earns $1 million, it might be worth $10 million. Similarly, if other companies are sold for 3 times their profit before expenses, and your company has $2 million in profit, it could be worth $6 million.
There are a few types of market-based valuation and some key terms to understand, including:
Comparable Company Analysis (CCA)
Comparable Company Analysis, or CCA, involves comparing the business to similar publicly traded companies.
Key financial metrics like P/E ratios, EBITDA multiples, and revenue multiples are analyzed to estimate the business's market value.
Precedent Transactions
Precedent transactions involve reviewing past M&A deals involving similar businesses.
By analyzing the multiples paid in these transactions, you can estimate a current valuation based on what buyers have paid before for similar companies.
Market Capitalization
Market capitalization is the total market value of a company’s outstanding shares of stock. This is calculated by multiplying the current share price by the number of outstanding shares.
This metric is used to gauge the overall size of publicly traded businesses and can help compare different companies within the same industry.
2. Asset-Based Valuation
Asset-based valuation is, as you may have guessed, a business valuation method that determines the value of a business based on its assets minus its liabilities.
This approach is often used in cases where a business's assets are its most valuable aspect or if the business isn't generating strong profits.
Some key factors are included in this type of valuation, including:
Book Value
The book value is the value of a company’s assets as recorded on its balance sheet minus liabilities.
This represents the net worth of the business from an accounting perspective.
Liquidation Value
The liquidation value is how much money could be recovered if a company’s assets were sold off quickly, usually in a dire situation.
It’s almost always lower than the book value because it accounts for the rushed sale of assets.
Replacement Cost
Replacement cost is how much it would cost to replace a company’s assets with new ones.
This method reflects how much it would cost to rebuild the business from scratch, using today’s prices for equipment, inventory, and other assets.
3. Income-Based Valuation
Last but not least is income-based valuation. This method estimates the value of the business based on how much revenue it will likely generate in the future.
This could be done a few different ways; by projecting the company’s cash flows for several years and then discounting them to present value, dividing the business's expected earnings by a rate that reflects the risk and return required by investors, or applying a standard industry multiple to the business's current earnings to estimate its value.
There are the three most important pieces of that puzzle:
Discounted Cash Flow (DCF)
Discounted Cash Flow (DCF) predicts the business's future cash flows and then discounts them back to their present value using a discount rate that reflects the risk and time value of money.
Capitalization of Earnings
Capitalization of Earnings calculates the business’s value by dividing its expected future earnings by a capitalization rate that reflects the return required by an investor, considering the risk level.
This is a simpler approach than DCF and is best for smaller businesses with stable earnings
Earnings Multiplier
The earnings multiplier applies a multiple based on industry standards to the business’s earnings to estimate its value.
This method is often used when detailed future earnings projections aren’t possible.
Finalizing Your Business Valuation: Review & Adjustments
Once you’ve selected your business valuation method and come up with a good number, take some time to look over it and adjust as needed.
Revisit the estimates made during the valuation process, including growth projections, market conditions, and industry multiples.
Take into consideration any unique factors affecting your business, like recent innovations, brand strength, or key contracts, which you could have missed in the standard calculations.
Consulting with financial advisors or valuation experts provides valuable insights to ensure that your final valuation reflects the actual worth of your business in the current market. Adjustments could be required to account for these nuances, making your valuation more accurate and credible for potential buyers.
Common Misconceptions About Calculating Business Value
There are a few common misconceptions when it comes to calculating your small business value.
One common mistake is believing that revenue alone determines value. In reality, profitability and cash flow are often more important to the big picture.
Another misconception is that asset value equals business value, which ignores intangible assets like brand reputation or customer loyalty.
Another false assumption is that valuation multiples are static when they actually fluctuate based on industry trends and economic conditions.
Lastly, many overlook the importance of adjusting for liabilities, which could absolutely impact the final valuation.
Frequently Asked Questions
How do I calculate the value of my small business?
To calculate the value of your small business, determine which valuation method is best for you (market-based, asset-based, or income-based) and consider all of the factors involved in the valuation method. Have a financial advisor help you finalize your valuation proposal.
How much is a business worth with $300,000 in sales?
A business with $300,000 in sales is worth $732,000, depending on the valuation method, industry, and multiples.
How much should a small business be sold for?
How much a small business should be sold depends on multiple factors, but most small business owners sell their business for 2-3x what it’s worth.
What is the most common way of valuing a small business?
The most common way of valuing a small business is the multiples method or the Discounted Cash Flow (DCF) method.
What are profitability adjustments?
Profitability adjustments can include various factors, such as changes in loss reserves, the impact of new business, adjustments for deficiency reserves, deferred tax liabilities, and realized capital gains.
What does multiples mean when valuing a business?
Multiples are multiplying factors/ratios calculated based on how much comparable businesses in the same industry are sold for.
Claire Fountain
