Nearly every owner carries a private number for what the business is worth. It is usually anchored to something unreliable — what a competitor sold for, what a broker mentioned at a conference, or what the owner needs it to be worth to retire.
The actual number comes from a fairly mechanical process, and understanding it is useful long before you intend to sell. The factors that determine value are largely the same factors that determine how well the business runs.
Earnings first, multiple second
Almost all small business valuation reduces to earnings multiplied by a multiple. Both halves require care.
Seller’s discretionary earnings (SDE) starts with net income and adds back interest, taxes, depreciation, amortization, one owner’s total compensation, and non-recurring or personal expenses run through the business. It represents the total benefit available to a single owner-operator. SDE is the standard measure for businesses where the owner works in the business day to day.
EBITDA adds back interest, taxes, depreciation, and amortization — but not owner compensation, because it assumes a market-rate manager is being paid. It is the standard measure once the business has management depth.
These are not interchangeable, and confusing them is the most common valuation error owners make. Applying an EBITDA multiple to an SDE figure overstates value substantially, because SDE includes a salary that EBITDA has already deducted. A business with $600,000 of SDE and a $200,000 market salary has $400,000 of EBITDA — and a 5× EBITDA multiple gives $2.0 million, not the $3.0 million that 5× SDE would suggest.
Normalizing the earnings
Before any multiple is applied, earnings are adjusted to reflect what a buyer would actually inherit.
Legitimate add-backs include one-time legal costs, personal vehicles and travel, above-market rent paid to an entity you own, and family members on payroll who do not work in the business. Legitimate deductions include below-market rent that will reset, deferred maintenance, and — critically — a market-rate salary for any owner or family member whose role a buyer would have to replace.
Buyers scrutinize add-backs closely, and each one you cannot document reduces credibility across the whole set. Clean books are worth real money at this stage, because add-backs that trace to source records survive diligence and those that do not are simply removed from the calculation.
Where the multiple comes from
Multiples reflect risk and growth. Broad ranges by industry exist and are widely published, but the range within an industry is wider than the range between industries — which means the specifics of your business matter more than its category.
Factors that push a multiple up:
- Low owner dependence. If the business runs without you for a month, it is worth more than one that stops when you take a holiday. This is usually the single largest driver.
- Recurring or contracted revenue. Predictable revenue is worth a premium over project work that resets to zero each January.
- Customer diversification. Concentration above roughly 20% in one customer discounts a price; above 40% it can make a business unsellable at any price.
- Documented systems. Written processes transfer; institutional knowledge in the owner’s head does not.
- Clean, reviewed financials. Statements that survive diligence without surprises.
- Growth with margin intact. Growth alone is not enough if it came from discounting.
Asset and market approaches
Earnings multiples dominate, but two other approaches appear.
The asset approach values the business as the net value of its assets. It sets a floor and is most relevant for asset-heavy or marginally profitable businesses — if the assets are worth more than the earnings support, the assets are the answer.
The market approach compares actual transactions for similar businesses. It is only as good as the comparability of the data, and private transaction databases vary in quality.
Revenue Ruling 59-60, issued in 1959 and still the foundational IRS guidance on valuing closely held stock, lists the factors to consider: the nature and history of the business, the economic outlook, book value and financial condition, earning capacity, dividend-paying capacity, goodwill, prior sales of stock, and the market price of comparable public companies. Any credible valuation addresses all of them.
Estimate versus appraisal
There is a real distinction between a planning estimate and a formal valuation.
An estimate — including our business valuation calculator — gives you a range to think with. That is genuinely useful for exit planning, for deciding whether to invest in growth, and for knowing roughly where you stand.
A formal valuation is required whenever the number will be relied upon by someone else: a buy-sell agreement, gift or estate tax reporting, a divorce or shareholder dispute, ESOP transactions, or SBA financing. These are prepared under professional standards by a credentialed appraiser, and a spreadsheet estimate will not substitute. The American Society of Appraisers maintains the standards such work is performed under.
The part worth acting on
The most useful insight from a valuation exercise is rarely the number. It is the gap analysis.
If your business is worth 3× and comparable businesses with management depth and recurring revenue sell at 5×, the difference is not luck — it is a list of specific, addressable conditions. Reducing owner dependence, diversifying customers, and documenting processes are each achievable in a few years, and each moves the multiple.
Moving the multiple by one turn is worth exactly one year of earnings. For most owners that is a far larger prize, and a more attainable one, than growing profit by the equivalent amount.