How to value a small business before anyone makes an offer

The first number spoken in a negotiation tends to anchor everything after it. If a buyer or an investor names a value for your business before you have worked out your own, you spend the conversation reacting to their number instead of explaining yours. Know your number before they name theirs.

This post covers how small businesses are valued in practice, the earnings figure buyers use, why two businesses with the same profit can be worth very different amounts, and how to work out a range for your own.

A value is a range, not a number

There is no single correct value for a business. A valuation is an estimate built on assumptions: which earnings to count, what a buyer in your industry would pay for them, how fast the business will grow. Change an assumption and the answer moves.

A price is something else. It is what one buyer agrees to pay on one day, with terms attached: how much is paid at closing, how much later, and on what conditions. A good valuation tells you where a fair price is likely to sit. It does not tell you what anyone will pay.

So the goal is a range you can defend, with the assumptions written next to it, rather than one figure to the dollar.

The three ways a business is valued

A multiple of earnings

Most owner-run businesses are valued as a multiple of their yearly earnings. If businesses like yours change hands at three times earnings and yours earns $150,000 a year, the starting point is $450,000.

The two halves do different jobs. The earnings figure carries the arithmetic, and it is where most of the arguments happen (more on that below). The multiple carries the judgment: it rises with growth, steady results and lower risk, and falls with the opposite.

A multiple of revenue

Companies that are growing fast but not yet profitable, such as subscription software businesses, are often valued on revenue, because today’s earnings say little about what they will earn later. Revenue multiples also appear as a rough check in industries where margins are similar from one business to the next.

Discounted cash flow

A discounted cash flow (DCF) values a business as the cash it will produce in future years, discounted back to today at a rate that reflects the risk of not getting it. It is the most rigorous method in principle and the most sensitive in practice: nudge the growth rate or the discount rate and the answer can move a long way. For a small business it works best as a cross-check on the multiple rather than as the headline figure.

There is also a floor: the value of the assets (equipment, stock, property) less the debts. A profitable business is rarely worth less than its assets would fetch, and an unprofitable one may not be worth much more.

Which earnings: SDE or adjusted EBITDA

Buyers of small businesses rarely take the profit line from your tax return as it stands. They rebuild it to show what the business would earn for a new owner.

SDE suits a business the buyer will run themselves: a café, a shop, a small agency. For a larger business, where the buyer will hire someone to run it, buyers use adjusted EBITDA: earnings before interest, tax, depreciation and amortization, with the same one-off adjustments, but with a market salary for the owner’s job taken off as a cost.

Here is a café’s year, rebuilt both ways:

The same café gives two quite different earnings figures depending on who the buyer is, and the multiple applied to each will differ too. Agree on which earnings you are talking about before you argue about the multiple.

Every add-back needs evidence: a payroll record, an invoice, a settlement letter. A buyer will accept the owner’s salary without a fight. They will question a “one-off” that turns out to happen every year, and family members on the payroll who do real work.

What moves the multiple

Two businesses with the same earnings can sell for very different multiples. The usual reasons:

• Track record. Three years of clean monthly figures are worth more than one good year. Gaps and restated months cost you.
• Growth. Rising earnings support a higher multiple than flat ones.
• Steady margins. A margin that swings from month to month makes next year harder to predict, and a buyer prices that in.
• Profit that turns into cash. Earnings tied up in unpaid invoices or unsold stock are worth less than earnings in the bank.
• Customer concentration. If one customer brings in a large share of revenue, losing them would change the business. Buyers price that risk.
• Owner dependence. If customers, suppliers and staff all rely on you personally, the buyer is paying for a business that may not run the same way once you leave.
• Recurring revenue. Contracts and subscriptions are worth more than sales that have to be won again every month.
• The books themselves. Monthly figures that match the bank and the tax returns make every other number believable.

Most of these can be improved in the year or two before a sale. Our post on preparing to sell goes through each one.

Startups are valued differently

A company with little revenue and no profit cannot be valued on earnings. Investors in early startups use methods built on the team, the market and the round itself: the Berkus method, the Scorecard method, the risk factor summation method and the VC method, which works back from a hoped-for exit. Our startup valuation guide runs one company through each of them.

How to work out your own range

1. Get monthly figures you trust for at least two years, ideally three, matched to the bank statements.
2. Rebuild the earnings. List each add-back with the document that supports it.
3. Pick the measure a buyer would use: SDE if they would run the business, adjusted EBITDA if they would hire a manager, revenue if you are growing fast and not yet profitable.
4. Apply a range of multiples, not one. Starting points for your industry are where to begin; your track record, growth and risks move you up or down within the range.
5. Cross-check with a discounted cash flow built from the same forecast.
6. Write the assumptions down beside the answer, so you can explain each one when someone challenges it.

What you end up with is a range you can explain rather than a number you hope for.

Keep your number to yourself until it helps you

Working out your value does not mean announcing it. The first number on the table anchors the conversation, so it should come from whoever has done the work, at the moment it helps them.

In Replafin the valuation is worked out from the same model as your statements and plan. The Accountant view sets the methods side by side: a multiple of the next twelve months’ revenue or EBITDA, a discounted cash flow, an NPV build, residual income, the VC method and, for startups, the Berkus, Scorecard and risk factor methods, with a football field to show the spread. The multiples start from US starting points for each kind of business, listed on the templates, there to be changed rather than quoted. The Owner view keeps it to one plain answer under What it might sell for: a low, middle and high figure from your plan, with the workings a click away.

None of it leaves the workspace unless you choose. When you share a version with investors, the valuation is switched off by default, so the conversation starts from the price you ask for. A valuation is not a price, and nothing here is investment advice: it is a starting point for the conversation you will have with your accountant, an adviser or a buyer.