How To Value a Small Business

How To Value a Small Business (Key Factors You To Consider Before Buying or Selling)

By Russell Bowyer

The way I valued the business I bought, was to use the profit multiplier method, but before I explain what that is and how this method works, it’s important to define what a small business is.

The way to value a small business is to use the profit multiplier method. This is calculated using profit, multiplied by a multiple between 1-3-times profits. Use an average of 3 year’s EBIT and add-back seller wages and benefits, one-off income and costs and deduct the cost to replace the owner.

The definition of a small business depends on who you speak with, or who’s defining it, but for the purpose of buying a small business, I’d define it as a business with sales of less than $10 million Dollars or Pounds.

But ideally it’s a business with sales of between $1 to $5 million Dollars or Pounds.

The business I bought had sales of about $2 million dollars, or £1.6 million pounds, so its sales sat perfectly in this $1-$5 million-dollar range.

The profit multiplier small business valuation method suites this type of business, which is where you are effectively buying its future profits, or future cash flows.

I would therefore suggest, the best way to value a small business, especially when you’re buying profits, is to use the profit multiplier method.

But also, this method of valuing a small business is probably the most recognised and most popular way to do so. But, just because it’s the most common way to value a small business, it doesn’t mean that everyone who uses this method will use it in exactly the same way.

I explore this point further in this video. But first, let me explain what the profit multiplier method is.

What is the profit multiplier methos to value small businesses?

The profit multiplier method is where you take the profits of the business, and multiply these profits by a number, or the multiplier.

Now, on the face that sounds simple, when actually it’s not as straightforward as it first appears, and let me explain why.

The first question to ask, is what profits should be used in the valuation calculation when using the profit multiplier method?

You may say, “surely profit is profit”, but profits are not always equal, when it comes to small business valuations, as believe it or not, there are many different profit figures.

These various business profits figures include:

  1. Gross profit;
  2. Profit before tax;
  3. Profit after tax;
  4. EBIT, which is earnings (or profit) before interest and tax;
  5. EBITDA, which is earnings (or profit) before interest, tax, depreciation and amortisation, and;
  6. There’s SDE, which is seller’s discretionary earnings, which is EBITDA, but with the sellers earnings and benefits added back, and adjusted for non-recurring income and costs.

But actually, non of these are the right profits to use to value a small business, and it’s important to use the right profit figure, to avoid over or under valuing a business.

The other complication with choosing the “right” profit figure for business valuation purposes, is that profits of a company are never the same from one year to the next. 

Profits fluctuate, as you’d expect.

Which profit is used to value a small business?

So, which profit do you use to value a small business, and as profits fluctuate from one year to the next, how do you calculate a profit figure to use?

The best profit to use for small business valuation, is to start with EBIT, which is “earnings (or profit) before interest and tax“, and then adjust this figure with various add backs and deductions, which is similar to, but not exactly the same as SDE, or seller discretionary earnings.

Don’t use EBITDA to value a small business when using the profit multiplier method, as many people suggest you should, because if you add back depreciation and amortisation, which is what the “D” and “A” stand for, you’ll over-value the business, and you’ll end up over-paying for the business.

To arrive at EBIT, you need financial statements for the business for at least three year’s trading.

Then turn to the profit and loss page of these financial statements, and look for the line described as “profit before tax”, which should be fairly easy to find.

On the same profit and loss page you should also see disclosed, interest payable and interest income. Deduct from the “profit before tax” any interest income, and add back any interest paid, and this will give you your EBIT number.

Do the same exercise for all three years of trading.

Then ask the seller for details of amounts they paid to themselves from the business, including any payments to members of the family, if these family members won’t be carrying on working in the business, post sale.

You need details of their salaries (or wages), benefits, company car costs, pensions and so on.

These are all those costs that will disappear, once the business is your company.

Add these amounts back to your EBIT number, for each of the three years.

Then review the profit and loss for each of the three years, and look for any income or costs that are likely to be non-recurring.

Non-recurring costs would include one-off legal costs, bad debts, excessive repairs or refurbishment costs, losses on sale of equipment, and so on. These costs need to be added back to the profit for each of the relevant three years of trading.

Non-recurring income might include profits on sale of equipment or any other income that is a one-off. This income needs to be deducted from the profits for each of the relevant three years of trading.

You now need to estimate the cost associated with replacing what the owner does in the business, as this work will still need to be done, after they’ve left, and when you own the business.

If there is more than one owner, the same applies for all owners, as it’s important to know what they each do in the business, and what this will cost to replace them once you’ve bought the company.

Calculate a salary for the role of the owner or owners, together with any associated employment costs, and deduct this amount from the profit figure for each of the three years.

How to choose the correct profit to value a small business

So, now you have three years of adjusted EBIT profit figures for the business. But now you need to decide which of these to use to value the company?

You could use a simple average of all three years, by adding the three years profits together and dividing by three. Or better still, you could use a weighted average calculation instead.

If you use a weighted average calculation, I suggest you give the latest year a higher weighting versus the older two years, and perhaps even use a 70% weighting for the latest year, 20% for year two and 10% for year three.

But there are no hard and fast rules on this calculation.

You also need to be mindful about giving too high a weighting to a year where the profits are unexpectedly high or unexpectedly low, as this may distort your profits, and therefore distort your valuation too.

Business valuation is not an exact science, so it really boils down to what you are prepared to pay for a business, but it’s also about how you intend to fund the acquisition too, as the amount you agree to pay for the business will impact on how you fund the purchase.

Next is how you calculate the profit multiplier, but before I explain this, and as a very quick aside, I have a great tool you can use to help you value a small business, which is included in the “Business Buying System”. This tool makes the calculation of business valuations far easier.

The other option you have is to take a look at my course, which is the 5-steps to buy a million-dollar business, which not only includes lessons on how to value a business, which is one of the 5 steps, but it also includes the Business Buying System as a free download too.

Back to how you value a small business…

How to calculate the profit multiplier when valuing a small business

So, now that you have your profit figure for valuation purposes, you need to ask the next question; “what multiplier do you use to multiply the profit you’ve just calculated“.

How do you determine this number?

Calculating the profit multiplier is very much a subjective process.

For example, I’m sure if you had a room full with entrepreneurs and business brokers, each one would probably use a different number, as a profit multiplier for any given business.

The factors to consider in arriving at a profit multiple, include:

  1. The size of the business, where for example, the bigger the business in terms of sales and profits, normally the higher the profit multiplier and the greater the business value;
  2. The business sector can affect the profit multiplier;
  3. Reliance on the owner will affect the profit multiplier, where the more reliant the business is on the owner, the lower the multiple, and therefore the lower the business value.

There are no hard and fast rules for how you determine what the profit multiplier should be, but so long as the business has:

  1. Sales in excess of 1 million Pounds or Dollars;
  2. It has profits of at least 100,000 Pounds or Dollars;
  3. The business isn’t too heavily reliant on the owner;
  4. The business or the business sector isn’t too volatile, plus;
  5. The business’s sales do not comprise more than 10-15% from one customer.

You should be looking at a profit multiplier of between 2 and 3 times profit.

I suggest for small business valuation purposes you don’t use a profit multiplier of greater than three, but it’s likely to be more than one.

That’s not to say it can’t be lower than one in certain circumstances, it just depends on the business, and surrounding factors.

You may argue that this is way too vague, and you’d be correct, but I’m afraid that’s how it is.

Having said that, let me try to help you further.

How to avoid over-paying when you buy a business

If you are looking to buy a business, and you want to avoid paying too much for it, I suggest you set a range of prices between 1 and 3 times the profit figure that you’ve calculated.

For example, let’s say the adjusted profit figure for a business you’re looking at is say £200,000, if the profit multiple is two, the value will be £400,000, which is two times £200,000.

But if the profit multiplier is three-times, the value will be £600,000, which is three times £200,000.

You now have an upper valuation figure (I.e. £600,000) and a lower valuation figure (I.e. £400,000) for this business, which are numbers you need to calculate, before you meet the owner to negotiate on price.

When you meet the owner, and ask them to reveal how much they want for their business, you have your upper and lower range numbers in your pocket to gage the number revealed by the seller.

If the number they reveal is below your lower limit, you know you have a great deal. If this is the case, you now need to negotiate how you pay for the business.

If their number is somewhere in between your upper and lower values, you may still have a good deal, but you may want to negotiate them down at this stage.

It’s important to highlight at this stage why it’s important you get the owner to reveal their number first. If they go first, the only way the negotiations can go is down.

But also, let’s say you went first and revealed your lower valuation of £200,000, but what if the number the owner was about to reveal was £150,000; this negotiation has just cost you an extra £50,000.

Also, if you go first, the only way the negotiation can go; is up, so you must stand firm and ask the owner to reveal their hand first. This is true even if the business has been valued by a business broker, ask the seller what they think the business is worth, because they may not agree with the broker’s valuation.

Finally, if the valuation number they reveal is higher than your upper valuation amount, you now need to negotiate the seller down.

But if they won’t budge to a more reasonable valuation number, you should consider walking away from the deal, to avoid over-paying for the business.

It’s important you get comfortable with the amount you pay for the business. But as already mentioned, there is a second element to this part of the negotiation, which is how the agree price will be paid, and over what period.

The ideal scenario, and a win for you, is to negotiate seller financing to fund the acquisition.

But seller financing isn’t just a win for you, it’s also a win for the seller too.

The seller benefits because they actually get to sell their business, where otherwise they might not sell at all, but also, it means the transaction will happen far quicker, than if it was financed by a bank loan instead.

You may then ask, is there a more simple way to value a small business instead? Well, I think there is, but only slightly, and it goes something like this.

For this to work, you need to ask the seller how much money they need to earn, once they’ve sold their business. This is best explained by way of an example.

Let assume that the seller needs to earn around 50,000 pounds or dollars a year, once they’ve sold their business.

Let’s also assume they can invest the sale proceeds, and earn say 5% on their money.

This would mean they need to sell their business for 1,000,000 pounds or dollars. But if this is a profitable business, making profits in excess of £350,000 a year, a 3-times multiple will work in this case. In other words, three times £350,000 is £1,050,000.

Unfortunately, no matter how simple you want the valuation process of a small business to be, you can’t really get away from the starting point of having to calculate a profit figure. Having a profit figure is the starting point of all negotiations, and in this case is the calculation you need to do, to confirm if the amount the seller needs to invest to achieve what they need to earn is reasonable.

To sweeten the deal for the seller, you could offer to pay a higher rate of interest than the 5% they can get from a bank on the amount financed using seller financing.

At the end of the day, if you are looking at a good profitable business, and if the owner is willing to offer seller financing, and so long as the business itself is sound, you can’t go too far wrong by paying a multiple of profits of somewhere between 2 and 3, so long as when you arrange the seller finance, the payment period is such that the business can afford these repayments.

If you have any questions on this topic about buying a business, or on any other aspect about the process involved in buying a business, please drop a comment below.

And always remember that no question is a stupid question, if you don’t know it, you don’t know it, and by having the answer to a question you have, might be all it takes to move to the very next step in your journey to buy a business.