How are small businesses valued?

Small owner operated businesses are typically valued based on something called "Sellers Discretionary Earnings" or SDE for short.

How are businesses valued?

As an entrepreneur this is probably a question you’ll wonder one day. Even if you aren’t looking to sell your business or land an investment, its still useful to have a rough idea of what the fruits of your labor are actually worth.

There are many ways you could approach a business valuation, each method having its own pros and cons. The three most common approaches are as follows:

Multiples approach
- This is by far the most common approach to valuing small “main street” businesses.
- This approach looks at financial metrics such as EBIT, EBITDA, or SDE and attempts to value the business by assigning a multiplier to those metrics based on what similar businesses have actually sold for in the past.
- The benefits of the multiples approach is that it is easy to calculate and easy to understand as it doesn’t require complex financial analysis.
- The drawback of this approach is that it does not consider any unique qualities of the business such as proprietary assets. It also ignores crucial details such as working capital.
Discounted Cash Flow
- Discounted Cash Flow (DCF) analysis is an approach very commonly used by investment professionals for valuing larger organizations. Its a method of valuing businesses (or investments) based on both their current performance and projected future cash flows.
- The DCF formula is: CF_t /( 1 +r)^t where CF = cashflow in the period, r = the interest (or discount) rate, and t = the period number
- The primary benefit of this method is that it gives consideration to the value of future income.
- The main drawbacks of the DCF method is that it is more difficult to calculate and harder to understand compared to the multiples method. It also does not work well for main street businesses as there is so much uncertainty when it comes to these types of businesses that trying to assign a dollar value to future cashflows is difficult.
Asset based approach
- An asset based approach seeks to value the business based on the assets it owns.
- This method works well for businesses such as construction firms, furniture and appliance stores, car dealerships, etc. as it shows a potential purchaser what they are actually buying.
- The primary drawback of this method is that it doesn’t work well for service based businesses or firms that do not have a significant amount of inventory or PP&E. Businesses such as hair salons, consulting firms, etc. should not use this method.

what is a "main street" business?

There is no concrete definition for what a “main street” business is, however, the term generally refers to small owner-operated businesses under $5M in annual revenue. Local mom and pop businesses such as restaurants, clothing stores, and barber shops usually fall into this category. Most main street businesses are valued using a multiples approach.

How much is my business worth?

This answer will vary depending on the method you use for evaluating your business, but most main street businesses opt for the multiples approach based on something called “Sellers Discretionary Earnings” or SDE for short. SDE is essentially a measure of the businesses annual cash flow, and it represents the entire financial benefit your business would provide to one full-time owner. Larger businesses ($5M+) generally use EBIT or EBITDA.

SDE is calculated as pre-tax net income + interest expense + depreciation and amortization + compensation and perks paid to all owners (less the cost to replace any current owners) + discretionary expenses (auto expenses, cell phones, meals and entertainment, travel, etc.) + adjustments for non-recurring and extraordinary, non-operating revenue or expenses (lawsuits, natural disasters, etc.).

It may seem like a complicated formula at first glance, but all you’re really assessing is the total cash a business generates for its owners before any owners compensation is paid out. Depreciation and amortization are expenses that impact the bottom line of a business for tax purposes, but they do not have an actual impact on cash flow so those expenses are added back to net income for the valuation. Discretionary expenses such as meals and entertainment are also added back to net income as these expenses are optional, and the new owners may simply choose to cut them out of the budget when they take over. Adjustments for non-recurring and extraordinary non-operating expenses or revenue are made to normalize the financials, as a business valuation should not necessarily be impacted by something such as a natural disaster that resulted in a significant one-time expense for the business, assuming the business has since recovered…

Using the multiples approach you would assign a multiplier to the total SDE your business generated in its most recent fiscal year (or the 12 months immediately preceding the valuation) to determine a fair market value for the entire business. For example, if your SDE is $250K, and you’ve determined that a multiple of 2x to 4x is appropriate, then a fair asking price for your business will be between $500,000 and $1,000,000.

The multiplier you will use should be based on comparable sales in your industry, but a typical multiplier will be between 3x and 5x, and as a general rule of thumb, you’ll can use the following multipliers based on your SDE to get a rough estimate.