How to Determine the Worth of a Small Business If You Want to Sell — or Buy

It is critical to understand how to value a small business at any stage of its life cycle. Raising a new round of funding, applying for small-business loans, transferring ownership… Every financing event in the life of a small business necessitates some method of determining the company’s worth. Wherever you are in your company’s lifecycle, you’ll want to know how to value a small business as soon as possible. Feeling confident in your appraisal will assist you in determining how to pitch investors and raise funding, or how to price your business to find the right buyer.

A valuation represents the total worth of your company. You’ll use a formula to determine the worth of your company, taking into account its assets, earnings, industry, and any debts or losses. Entrepreneurs looking to buy an existing business should be familiar with valuations and feel comfortable estimating value independently of the asking price set by the business owner or broker.

If buying and selling businesses is a new experience for you, there are numerous online resources available to assist you in determining the value of a business. Even if you don’t intend to sell or already have an offer, understanding how to value a business — and determining your own — can help inform your company’s road map as well as future exit strategies.

Keys to determining the worth of a small Business

A valuation is an excellent opportunity to assess the financial health and potential of your company or a company you want to buy. Along with doing financial legwork, valuing your business necessitates exercising emotional control. Take care to approach valuation as objectively as possible, especially if this is your first company or if you run a family-owned and operated business, to arrive at an accurate number.

Recognize your valuation

Unless you’re a natural-born business or numbers person (or, say, an accountant), valuing a company is a difficult process. You must first understand some key definitions:

Earnings at the seller’s discretion

Even if you’ve never heard the term, if you’re familiar with EBITDA, you’re probably familiar with SDE, or seller’s discretionary earnings. To recap, EBITDA stands for earnings before interest, taxes, depreciation, and amortisation — in other words, it’s a company’s pure net profit.

SDE, like EBITDA, is calculated by business owners to determine the true value of their business for a new owner, so your SDE will include expenses such as the income you report to the IRS, non-cash expenses, and whatever revenue your business actually generates. Unlike EBITDA, you’ll also factor in the owner’s salary and benefits into your SDE calculation. Large businesses typically use EBITDA calculations to value their operations, whereas small businesses typically use SDE, because small-business owners frequently expense personal benefits.

Prospective buyers must understand SDE as well. Most likely, business owners will provide you with that number; therefore, it is critical to understand how the business owner arrived at that value, as well as what these values reflect about the actual business.

To determine your company’s SDE, begin with its pretax, and pre-interest earnings. Then you’ll subtract any non-essential purchases, such as vehicles or travel, that you report as business expenses. Employee outings, charitable contributions, one-time purchases, and your own salary can all be counted toward your SDE. (When you offer your valuation, buyers may inquire about your discretionary cash flow, so be prepared to include and value each major expense or purchase.)

Finally, any current debts or future payments, referred to as liabilities, are deducted from net income. More on liabilities later.

Multiples of SDE

Your SDE represents the true monetary value of your business, but it also values it according to industry standards. (If you value your company using EBITDA, you’ll use an EBITDA multiple.) Small businesses, in particular, should use SDE for business valuations because small-business owners typically take a large percentage of their company’s revenue for salary and living expenses.

Every industry has a different SDE multiple. The SDE multiple for your specific business will vary depending on market volatility, where your business is located, the size of your company, assets, and the amount of risk involved in transferring ownership. As you might expect, the higher your SDE multiple, the more valuable your company is.

Get your finances in order

Because determining the value of a small business is a complicated process, you may want to consult a professional business broker or accountant who specializes in valuation rather than going it alone. You can, however, fully value your company using your own resources. But first, you must organize your financial information.

Before considering how to value a small business for sale, both sellers and buyers must organize their financial records — this is critical for accurate calculations. In addition to conducting your valuation, you’ll need your finances to transfer business ownership.

To ensure a smooth valuation process, sellers must have the following documentation:

  • Licenses, deeds, and other confidential documents
  • Profit and loss statements for the previous three years are provided
  • Tax returns and filings
  • A brief overview of your company’s or personal finances

A quick reminder about those tax returns: Many purchases you reported as business expenses to the IRS, such as the cost of travel, a personal vehicle, and many other non-essential, one-time purchases, should be added back to your earnings when calculating your SDE.