Determining what your business is worth is a primary question for any owner thinking about their next chapter. The process of arriving at a sale price is a detailed evaluation that combines financial data with an assessment of the business’s operational strengths and weaknesses. It involves looking at your company from the perspective of a potential buyer to see its true earning power.
Understanding Seller’s Discretionary Earnings
For most small to medium-sized businesses, the starting point of a valuation is not the net profit on a tax return, but a figure known as Seller’s Discretionary Earnings (SDE). SDE represents the total financial benefit a single owner-operator derives from the business. It is designed to show a potential buyer the actual earning capacity of the company before any owner-specific financial decisions are factored in.
The calculation begins with the company’s pre-tax net profit and adds back expenses that will not be carried over to a new owner. The formula is: SDE = Net Profit (before tax) + Owner’s Salary + Interest Expense + Depreciation/Amortization + Discretionary Expenses. These “add-backs” include the current owner’s salary, benefits like health insurance, and any personal expenses run through the business not related to core operations.
Consider a small consulting firm with a pre-tax net profit of $150,000. The owner pays themself a salary of $80,000, and the business has an interest expense of $10,000 and depreciation of $20,000. The owner also runs personal vehicle expenses of $15,000 through the company. The SDE would be calculated as $150,000 + $80,000 + $10,000 + $20,000 + $15,000, which equals $275,000. This figure reflects the cash flow available to a new owner.
Common Business Valuation Methods
Once a clear SDE figure is established, it can be used in several valuation methods to arrive at an estimated sale price. The most appropriate method depends on the size, type, and profitability of the business. A combination of methods often provides the most realistic picture.
SDE Multiples
The most common valuation method for main street businesses is the SDE multiple. The approach involves multiplying the calculated SDE by an industry multiple. These multiples range from two to four but can vary based on the specific industry, its risks, and growth trends. For instance, a business with an SDE of $300,000 and an industry multiple of 3x could be valued at $900,000.
EBITDA Multiples
For larger businesses with established management teams where the owner is not central to daily operations, the EBITDA multiple method is more common. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Unlike SDE, this calculation does not add back the owner’s salary, as a new owner would need to pay a manager. Multiples for EBITDA are higher than for SDE, ranging from three to six or more.
Asset-Based Valuation
An asset-based valuation calculates a company’s worth based on the fair market value of its assets minus its liabilities. This method is most relevant for businesses whose value is tied to physical assets, like manufacturing plants, or for businesses that are not currently profitable. The two main approaches are the book value method, which uses balance sheet figures, and the liquidation value method, which estimates cash generated if all assets were sold. This approach often sets a floor for the business’s value, as it doesn’t account for future earning potential.
Factors That Influence Your Business’s Final Sale Price
The multiple applied to your SDE or EBITDA is not a fixed number; it is influenced by a range of qualitative factors that assess the risk and future potential of the business. A strong business can command a higher multiple, while one with significant risks will see its multiple reduced.
A consistent history of revenue and profitability is a primary driver of value. Buyers look for stable or growing financial performance as it reduces their perceived risk. A business with volatile earnings will likely receive a lower multiple than one with a steady, predictable cash flow. Clean, well-organized financial records are also important.
The degree to which the business relies on its current owner is another major consideration. A company that can operate smoothly without the owner’s constant involvement is more valuable because the transition to new ownership will be easier. If all customer relationships and operational knowledge rest with one person, the business carries a higher risk for a buyer, which can lower the valuation multiple.
The stability of your customer base also plays a role. A business with a diverse group of clients is less risky than one that relies on a few large customers for the majority of its revenue. Losing a single client could be detrimental to a business with high customer concentration. Long-term contracts or recurring revenue models, such as subscriptions, add value by demonstrating predictable future income.
Well-documented systems and processes that allow the business to run efficiently are attractive to buyers. When operations are standardized and can be easily taught to a new owner, the perceived risk of a transition is much lower. Scalable systems suggest that the business can grow without a proportional increase in costs.
The potential for future growth and the conditions of the broader market will impact the sale price. A business in a growing industry with clear, identifiable opportunities for expansion will command a higher multiple. Buyers are purchasing future profits, so a compelling growth story, backed by evidence, can increase what they are willing to pay.
How to Increase Your Business’s Value Before Selling
Preparing your business for sale is an opportunity to proactively address weaknesses and enhance its strengths to command a higher price. Many of these actions are directly related to the risk factors that buyers assess. By methodically improving your operations and financial presentation, you can influence the valuation multiple.
To reduce owner dependency, begin documenting all operational processes. Create standard operating procedures (SOPs) that would allow someone new to step in and understand how things are done. Delegating major responsibilities to capable employees and empowering your management team also demonstrates that the business can thrive beyond your tenure.
Improving financial performance involves more than just increasing sales. Focus on growing high-margin revenue streams and securing recurring income through contracts or subscriptions. Review all expenses and cut unnecessary costs to boost profitability. Cleaning up your financial statements by removing personal expenses will make your SDE calculation more defensible.
To address customer concentration risk, launch marketing and sales initiatives aimed at diversifying your client base. Ideally, no single customer should account for more than ten percent of your total revenue. This diversification demonstrates a more stable and predictable revenue stream, reducing the risk for a potential acquirer.
Getting a Professional Business Valuation
While the methods described can provide a solid estimate, this calculation is no substitute for a formal valuation conducted by a professional. Certified business appraisers or experienced business brokers bring a level of objectivity and expertise that is difficult to replicate. Their analysis provides a comprehensive and defensible assessment of value.
A professional valuation offers numerous benefits. It provides a credible, third-party number that becomes a strong foundation for negotiations with potential buyers. This formal report can also uncover hidden risks or opportunities that an owner might overlook, providing a roadmap for value enhancement before a sale.
Engaging a professional makes sense when you are seriously planning to sell within the next one to two years. It is also a necessary step for legal or tax-related events, such as estate planning or partnership buyouts. A professional valuation signals to buyers that you are a prepared seller, which can lead to a smoother transaction.