How to Value a Small Business Without Fooling Yourself

Learning how to value a small business usually starts with a number the owner already has in mind, and ends with the discovery that nobody else arrived at it. The gap between those two figures is not a negotiation problem. It is an arithmetic problem, and it is usually visible years before anyone is at the table.

This matters even if you have no intention of selling. The things that make a business worth buying are the same things that make it worth owning, and most of them take three years to build.

Why Owners Get the Number Wrong

Three mistakes, in order of how often they appear.

Valuing revenue instead of earnings. A business turning over two million and keeping ninety thousand is not worth more than one turning over four hundred thousand and keeping two hundred. Buyers pay for what reaches the owner, not for what passes through the account.

Counting the work you do for free. If the business only produces its earnings because you work sixty hours in it, a buyer has to hire someone to replace you, and that salary comes off the number before the multiple is applied.

Pricing the future rather than the past. The pipeline, the plan, the contract that is nearly signed. Buyers pay for the last three years. They discount everything that has not happened yet, because the risk of it not happening is theirs.

How to Value a Small Business: The Three Methods

Income based. Take the annual earnings the business produces for its owner and apply a multiple. For businesses under a few million in value this is the method that gets used, and everything else is a sanity check.

The earnings figure here is usually SDE, seller’s discretionary earnings. That is net profit plus the owner’s salary, plus one-off costs and any personal expenses running through the books. It answers a single question: how much cash would land in a new owner’s hands if they ran it the same way.

Market based. What comparable businesses in your sector actually sold for. Not what they were listed at. Asking prices are aspiration, closed prices are data.

Asset based. The value of what the business owns, minus what it owes. This sets a floor. For a service business with no equipment, that floor is close to zero, which tells you the whole value is in the earnings and the relationships.

The Multiples Buyers Actually Pay

Here is where most estimates collapse. The multiple people imagine is roughly double the one that transacts.

BizBuySell’s data across all sectors puts the average SDE multiple at 2.58 and the average revenue multiple at 0.67. The median sale price of a small business is $340,000.

By sector, online and technology businesses lead at 3.28 times SDE. Manufacturing sits at 3.04, service businesses at 2.61, food and restaurants at 2.27, transportation at 1.95.

So a service business producing $200,000 a year for its owner is worth somewhere near $520,000. Not two million. If that number is lower than the one in your head, the useful response is not to argue with it, it is to ask what would move you from 2.6 to 3.2.

What Destroys a Multiple

Owner dependence. If the relationships are yours, the expertise is yours, and the decisions are yours, then what is being sold is a job with your name on it. This is the single biggest discount applied to small businesses, and it is also the most fixable.

Customer concentration. One client at forty percent of revenue is not a strength. It is a risk the buyer inherits, and they price it.

Books that need explaining. Every hour a buyer spends reconstructing your numbers is an hour they spend wondering what else is unclear. Clean records are worth real money and cost almost nothing.

Revenue that does not repeat. Project work is worth less than a retainer producing the same money, because one has to be won again next year and the other does not.

What Raises One

The mirror image, and each takes time rather than money.

Documented process, so the work survives your absence. A second person who can hold the client relationships. Revenue spread across enough customers that losing one is annoying rather than fatal. Contracts that renew. Three years of accounts that need no commentary.

Notice that every one of those is also just a better business to own. That is not a coincidence, and it is why this is worth thinking about long before any exit. Building for a sale and building for yourself point in the same direction, which is unusual, and it is one of the few places where a decision that is expensive to reverse has an obvious right answer.

The Test to Run Now, Even If You Are Not Selling

Twenty minutes, once a year.

Work out your SDE for last year. Net profit, plus your own salary, plus anything personal running through the business, plus one-off costs that will not repeat.

Multiply by 2.6. That is your rough number today.

Then ask what a buyer would have to replace if you left tomorrow, and write the list. Every item on it is a discount.

Then pick one item and remove it this year. Not all of them. One.

That is second order thinking applied to your own asset. The first order question is what the business earns. The second is what happens to that number when you are not the one producing it, and the answer to that is what somebody is eventually buying.

Written By Victor Lanza
Editor, The Executive Insight