How To Value A Small Business Before You Buy It

Value Comes From Cash Flow

When you buy a small business, you are buying its future cash flow. The equipment, the customer list and the brand matter, but mostly because they produce that cash. That is why almost every method for valuing a small business starts with one number: what the business really earns for its owner.

Three questions drive the value:

1. How much does it earn? Based on tax returns and financial statements you can verify.
2. How reliable are those earnings? Recurring customers, a stable team and a steady trend make earnings more valuable.
3. Can the earnings repay the debt? On an SBA purchase, the cash flow has to cover the loan payments with room to spare.

Start With The Right Earnings Number

Two earnings measures show up in almost every small business sale:

• Seller's discretionary earnings (SDE). Net income plus the owner's salary and benefits, interest, depreciation, amortization and legitimate one-time or personal expenses. It shows what one full-time owner-operator takes home before debt. Most businesses selling for under a few million dollars are priced on SDE.
• EBITDA. Earnings before interest, taxes, depreciation and amortization, after paying a market salary for whoever runs the business. Larger companies with a management team are usually priced on EBITDA.

The difference is the owner's pay. A business with $500,000 of SDE and a $120,000 market salary for a manager has $380,000 of EBITDA. Multiples on EBITDA are higher than multiples on SDE for the same business, because the earnings figure is smaller.

Every add-back changes the answer, so get them right first. Our SDE and add-backs guide covers which ones hold up.

The Three Approaches To Value

Professional appraisers use three approaches and weigh them for each business:

Buyers mostly use the market approach, because it is fast and reflects what buyers actually pay. Sold-deal databases used by brokers and appraisers, and the asking prices on marketplaces, give you a feel for typical multiples in your industry. Asking prices are not sale prices, so treat them as the top of the range.

Choosing A Multiple

Two businesses with the same earnings can sell for very different prices. These factors push the multiple up or down:

• Size. Larger earnings usually earn a higher multiple, because the business is less fragile.
• Owner dependence. If the owner does the selling, the estimating and the hiring, the business is worth less without them.
• Customer concentration. One customer providing a large share of revenue is a risk buyers price in.
• Recurring revenue. Contracts, subscriptions and repeat service customers support a higher multiple.
• Trend. Growing earnings are worth more than flat or falling earnings.
• Capital needs. A business that must keep buying trucks or machines leaves less cash for the owner.
• Industry. Some industries simply trade at higher multiples than others.

A Worked Example

Here a buyer values a sign company using two earnings measures and an asset check, then sets a price range.

Then test the range against the debt. SBA requires a business purchase to show debt service coverage of at least 1.25. With $370,000 of cash flow after a manager's salary, the business can carry up to $296,000 a year of total debt payments ($370,000 divided by 1.25). Your lender can tell you what loan that supports. See DSCR for a business acquisition for the method.

Your Valuation Vs The Lender's Valuation

Your valuation is for you: it tells you what to offer and when to walk away. On an SBA purchase there is a second valuation that matters more for the financing.

SBA requires an independent business valuation on every change of ownership, and it has firm rules:

• A Qualified Source. The appraiser must be accredited as an ASA, CBA, ABV, CVA or BCA, and independent of the lender's loan production and approval.
• Prepared for the lender. The lender requests it and the appraiser prepares it for the lender. A valuation prepared for you or for the seller cannot be used.
• Small deal exception. When the Business Purchase Price is $350,000 or less, the lender may value the business itself, unless there is a close relationship between buyer and seller.
• Verified data. The lender checks the financial information the appraiser used against the seller's IRS transcripts.
• Real estate separately. A building in the deal gets its own real estate appraisal, and the Business Purchase Price excludes owner-occupied real estate.

The cost of the valuation can be included in the loan, and if you pay for it yourself, that money can count toward your Down Payment. More detail is in SBA business valuation requirements.

When Your Number And The Lender's Differ

The valuation must support the Business Purchase Price, no matter how the debt is structured. Two rules follow from that:

• If you pay more than the valuation, you cover the gap with equity. The SBA loan cannot fund it. A seller can carry the difference, but only as a note on full standby.
• Total debt is capped at the valuation. The SBA loan plus any seller note that is not on full standby cannot exceed the business valuation, and the cash flow must support all of it.

For larger deals, there is one more layer. At a Business Purchase Price of $3,000,000 or more, the lender also needs a Quality of Earnings report, and it must use the QoE earnings for the cash flow test. If those earnings come in lower, the loan is reduced. See the Quality of Earnings report guide.

Put It Into Your Offer

Once you have a range, use it. Write the price and structure into your letter of intent, make it subject to financing and the lender's valuation, and get a pre-qualification letter that shows the seller you can close at that number. This article is general information, not valuation, tax or legal advice; work with a CPA and an attorney on your deal. See the full product details on our SBA business acquisition loan page.