How do you value a business for sale?

You value a private business for sale by first restating its earnings to what a new owner would really receive, then estimating what those earnings are worth in three ways: a multiple taken from sales of comparable companies, the present value of the cash the business is expected to produce, and the value of its assets net of its liabilities. The three methods give three different numbers, and the valuation is the reasoned range you draw from them, not any single one.

The earnings measure comes before any method. A company run day to day by its owner is measured on seller's discretionary earnings, a company with a management team in place on EBITDA, and both are adjusted for items that will not continue under a buyer. Most of the disagreement between a seller and a buyer sits in those adjustments, long before anyone argues about a multiple.

This article works every step on one illustrative company. The practice described is the general one used in private company sales; tax rules, professional standards and the legal weight of a valuation report differ by country, and this is general information, not valuation, legal or tax advice.

Which earnings figure do you value: SDE or EBITDA?

You value seller's discretionary earnings when the buyer will work in the business as its owner, and EBITDA when the business will be run by paid managers. The choice follows the likely buyer, because each measure answers a different buyer's question.

Seller's discretionary earnings, usually shortened to SDE, are the pre-tax profit of the business plus interest, depreciation and amortisation, plus everything the business pays to or for one working owner, adjusted for items that will not recur. SDE is the pool from which an individual buyer will take a living, service the acquisition loan and reinvest.

EBITDA is earnings before interest, tax, depreciation and amortisation. It treats management as a cost: whoever runs the company is paid a market salary, and EBITDA is what is left afterwards. A corporate acquirer or an investment firm will not work in the business, so it looks at profit after the cost of the person who does.

The two are linked by one line. Adjusted EBITDA equals SDE less the market cost of replacing the owner with a hired manager. That link is why the two measures carry different multiples for the same company: a multiple of SDE is always lower than a multiple of EBITDA, because SDE is the larger number. Applying a multiple of one to the other is a common error in informal valuations.

Size usually decides which measure applies. The Market Pulse survey of business brokers and M&A advisors, published quarterly by the International Business Brokers Association and M&A Source, reports its multiples on SDE for sales under $2 million and on EBITDA for sales from $2 million to $50 million. A company near that line, like the one in this article, is worth computing both ways.

How do you normalise the earnings before applying any method?

You normalise earnings by adding back costs that a buyer will not bear and deducting benefits that a buyer will not keep, each adjustment supported by a document. Normalising, also called recasting, turns the profit shown in the accounts into the profit a new owner can expect.

The adjustments fall into four families:

• Financing and accounting items. Interest depends on how the present owner financed the business, and depreciation and amortisation are accounting allocations. Both are added back.
• Owner's compensation and benefits. The salary, pension contributions and personal expenses the owner runs through the company are added back in full for SDE. For EBITDA, a market salary for a replacement manager is then deducted.
• Non-recurring items. A one-off legal settlement, a relocation, a flood or an exceptional contract is removed, whether it reduced the profit or inflated it.
• Items not at market terms. Rent paid to the owner's own property company below the going rate, or a relative on the payroll who does not work in the business. Each is reset to the market figure, and the adjustment can go down as well as up.

The illustrative company is a commercial landscaping and grounds maintenance contractor with $4,200,000 of revenue, owned and managed by one person. Its accounts show a pre-tax profit of $318,000. The owner pays themselves $180,000, and a hired general manager for a company of this size is assumed to cost $150,000 all in. The owner also owns the yard and charges the company $60,000 a year in rent, where the market rent is assumed to be $96,000, so a buyer will pay $36,000 more.

Adjusted EBITDA is 12.2% of revenue and SDE 15.8%. EBITDA straight from the accounts, before any adjustment, would have been $456,000: the profit plus interest, depreciation and amortisation. The $58,000 gap between $456,000 and $514,000 is the net effect of the adjustments, and at any multiple it is worth several times that amount in price.

Three rules keep a normalisation credible. Use at least three years, so one good year does not set the price. Deduct what should be deducted, such as the cheap rent. And keep a document for every line, because the buyer's accountant will test each one in due diligence and a lender will fund only the earnings it can verify.

How does the market approach turn earnings into a value?

The market approach values a business by applying to its normalised earnings the multiple that buyers have paid for comparable companies. The method rests on what buyers have actually done, and its weakness is that truly comparable sales are few and their details are rarely public.

The multiple comes from completed transactions in the same trade and the same size range: sales the advisor has handled, subscription databases of private sales fed by brokers, and surveys published by trade bodies.

Size alone moves the figure. In the Market Pulse report for the fourth quarter of 2022, the International Business Brokers Association and M&A Source reported median multiples of 2.0 times SDE for businesses sold under $500,000, 2.8 times for sales of $500,000 to $1 million and 3.0 times for $1 million to $2 million, then 4.1 times EBITDA for sales of $2 million to $5 million. Those medians cover all industries in one quarter of one survey. They show that multiples rise with size, largely because bigger companies attract more buyers and cheaper financing, and they are not the multiple of any particular company.

For the worked example, assume comparable grounds maintenance contractors have sold for 4.0 to 5.0 times adjusted EBITDA, with 4.5 as the central figure. These multiples are illustrative. On adjusted EBITDA of $514,000:

• at 4.0 times, the value is $2,056,000;
• at 4.5 times, the value is $2,313,000;
• at 5.0 times, the value is $2,570,000.

The same company can be checked on SDE. At an illustrative 3.5 times SDE of $664,000, the value is $2,324,000, within $11,000 of the EBITDA result. A wide gap between the two would mean one of the multiples was taken from the wrong set of sales.

Before you apply any multiple, confirm what it was computed on: SDE or EBITDA, the last twelve months or an average, with or without stock and working capital included, and enterprise value or price paid for the shares. A multiple quoted without those four answers cannot be applied safely to your own numbers.

How does a discounted cash flow value the same business?

A discounted cash flow values a business as the sum of the cash it is forecast to generate, each year's cash reduced to its value today at a rate that reflects the risk of not receiving it. Where the market approach asks what others paid, the discounted cash flow, or DCF, asks what this company's own future is worth.

The method has four inputs. The forecast of free cash flow: earnings, less tax, less the capital expenditure needed to keep the business running, less the extra working capital that growth ties up. The discount rate: the annual return a buyer requires for the risk, which for a small private company is far above the rate on a bank loan. The terminal value: what the business is worth at the end of the forecast, usually computed by assuming the last year's cash flow grows at a low constant rate for ever. And the forecast period, commonly five years.

For the illustrative company, the assumptions are: adjusted EBITDA starting from $514,000 and growing with revenue by 5%, 5%, 4%, 4% and 3% over five years; tax at 25% of EBITDA less the $96,000 of depreciation; capital expenditure of $110,000 a year on vehicles and equipment; additional working capital equal to 10% of each year's revenue growth; a discount rate of 18%; and growth of 2.5% a year after year five. All of them are illustrative.

In year one, EBITDA of $539,700 less tax of $110,925, less capital expenditure of $110,000, less $21,000 of extra working capital on $210,000 of new revenue, leaves $297,775, and dividing by 1.18 gives $252,352. The terminal value is year five's cash flow grown by 2.5% and divided by the gap between the discount rate and the growth rate, 15.5 points.

Two readings matter more than the total. First, the five forecast years contribute $1,031,016 and the terminal value $1,076,620, so 51% of the result rests on what happens after the forecast ends. Second, the result moves sharply with the discount rate: at 16% the same cash flows are worth $2,427,978, and at 20% they are worth $1,860,895. A change of two points in one assumption shifts the value by more than the whole range of the market approach.

The DCF value of $2,107,637 is 4.1 times adjusted EBITDA, below the 4.5 times of the market approach. Either buyers in this trade accept a return below 18%, or they expect more growth than the forecast, or the comparable sales were of better companies.

What does the asset-based approach show, and when does it apply?

The asset-based approach values a business as the current worth of what it owns, less what it owes, ignoring what it earns. For a profitable operating company the asset figure is a floor and a reference point; for a holding company, a property-rich business or a company earning little, the asset figure is the valuation.

The method restates the balance sheet line by line from book value to current value. Equipment is taken at its appraised value, receivables are reduced for amounts unlikely to be collected, and liabilities are taken at what must be paid.

For the illustrative company, valued on the same debt-free and cash-free footing as the other two methods:

• receivables of $510,000, less $15,000 judged uncollectable: $495,000;
• stock of materials: $60,000;
• vehicles and equipment, appraised at $780,000 against a book value of $420,000;
• less supplier payables and accrued costs of $310,000.

The adjusted net operating assets come to $1,025,000. Set against the market value of $2,313,000, the difference of $1,288,000 is what a buyer pays for things no balance sheet lists: the contracts, the crews, the reputation and the routines that turn those vehicles into $514,000 a year. That difference is goodwill. A lender financing the purchase looks at how much of the price is backed by assets, and in a purchase of assets the split of the price between equipment and goodwill has tax consequences that depend on the country.

The asset approach takes the lead in three situations: the business earns less than a fair return on its assets, so a buyer would pay no goodwill; the company mainly holds investments or property; or the business is being wound down and the relevant figure is what the assets fetch in an orderly sale.

Why do the three approaches give three different numbers?

The three approaches give different numbers because each measures a different thing: the asset approach what the business owns, the discounted cash flow what its own forecast is worth at a chosen return, and the market approach what buyers have paid for similar companies. A valuation states all three and explains the weight given to each.

For a profitable service company, a valuer would normally give most weight to the market approach, use the DCF as a test of whether that multiple is consistent with a believable forecast, and report the asset value as the floor. The conclusion is then a range, here roughly $2.1 million to $2.3 million, with the reasons for sitting at one end or the other.

The methods also check each other. A market value far above the DCF value means the price needs growth that the forecast does not contain. A DCF value far above the market value usually means an optimistic forecast or a discount rate set too low. A market value close to the asset value means the business is barely earning a return on its equipment.

What moves the multiple up or down?

A multiple rises with the size, growth and predictability of the earnings and falls with every dependence on one customer, one supplier or the owner.

Concentration is easy to put a number on. Suppose one municipal contract represents 30% of the illustrative company's revenue and comes up for tender in two years. A buyer who would otherwise pay 4.5 times may offer 4.0 times, and on $514,000 of adjusted EBITDA that half turn is $257,000. Alternatively the buyer keeps the multiple and makes part of the price depend on the contract being renewed, which moves the question from value to terms.

Owner dependence is the factor a seller can change most before a sale. If the owner personally prices every job and holds every client relationship, the buyer will either lower the multiple or require a long handover and a deferred payment. Documented procedures, a second layer of management and contracts in the company's name, in place well before the sale, address it directly.

What is the difference between enterprise value and equity value?

Enterprise value is the value of the business operations whoever finances them, and equity value is what belongs to the owners once the company's financial debt is deducted and its cash added. Multiples of EBITDA and the discounted cash flow above all produce enterprise value: with $540,000 of bank debt and $120,000 of cash, the illustrative company's enterprise value of $2,313,000 corresponds to an equity value of $1,893,000.

The further adjustments that turn that figure into the amount actually paid on the day of closing, including the working capital target, transaction costs and amounts held back, are a subject of their own and are covered in the article on getting from enterprise value to the amount wired at closing. An offer for the shares and an offer for the business free of debt and cash can differ by hundreds of thousands of dollars and still represent the same value.

Why is the valuation not the price, and how do terms change it?

A valuation is an estimate of what a typical buyer would pay under stated assumptions, and the price is what one particular buyer agrees to pay, on particular terms. Two offers with different headline prices can be worth the same, or rank the other way round, once the timing and the certainty of each payment are counted.

Terms then decide what the headline is worth. Take two illustrative offers for the company on the same debt-free basis. Offer A is $2,300,000 paid in full at closing. Offer B is $2,500,000, made of $1,750,000 at closing, a $450,000 seller note repaid in five equal annual instalments at 7% interest, and an earn-out of up to $300,000 payable after two years if revenue targets are met.

The note pays $109,751 a year. If the seller judges that an unsecured loan to this buyer deserves a 12% return, those five payments are worth $395,627 today, not $450,000. If the seller rates the chance of collecting the earn-out at one in two and discounts it at 18% over two years, it is worth $107,728. On those assumptions offer B is worth $2,253,355, which is $46,645 less than offer A despite a headline $200,000 higher. Different assumptions give a different ranking, and a seller confident in the buyer and in the targets may rightly prefer B.

Brokers and M&A advisors add much of their value here. An intermediary's opinion of the most probable selling price reflects what buyers in that market are paying and on what terms, and a process run with several buyers is what turns a valuation range into a price at its upper end.

When should you commission a formal valuation, and which standards apply?

You commission a formal valuation when someone other than the two negotiating parties must be able to rely on the figure: a tax authority, a court, a lender, minority shareholders or the trustees of an employee share plan. For an ordinary sale between a willing seller and an informed buyer, a broker's or advisor's opinion of value is usually enough, because the market itself tests the number.

The usual occasions for a formal report are a transfer between family members or related parties, a gift or an estate, a divorce or a shareholder dispute, a buyout under a shareholders' agreement, a loan that requires an independent appraisal, and financial reporting after an acquisition. In each of them the report must say which standard of value it used.

Fair market value is the standard used for federal tax purposes in the United States. The Internal Revenue Service's Revenue Ruling 59-60 describes fair market value as the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion and both having reasonable knowledge of the relevant facts. Other purposes use other bases, such as fair value in a shareholder dispute or investment value to one specific buyer, and the same company can properly carry different figures under each.

Valuers work under published professional standards, and the engagement letter should name the one that applies.

The International Valuation Standards Council lists valuation approaches as its general standard IVS 103 and businesses and business interests as IVS 200. The standard of the American Institute of Certified Public Accountants, in force for engagements accepted from 1 January 2008, distinguishes two outputs: a conclusion of value, where the valuer chooses and applies the approaches judged appropriate, and a calculated value, where the valuer and the client agree in advance on a limited set of procedures. A calculated value costs less and is useful for planning, and it does not carry the weight of a conclusion of value before a court or a tax authority.

When you engage a valuer, four points belong in the engagement letter: the purpose of the valuation, the standard of value, the valuation date, and the interest being valued, since a 100% holding and a minority stake in the same company are not worth the same per share. A report prepared for one purpose should not be reused for another without asking its author.