Business Valuation Services: How Buyers and Lenders Value a Small Business

What valuation means when you plan to sell

A valuation for a sale answers a narrow question: what price range a qualified buyer is likely to pay, on terms a lender is likely to finance. That is different from what the business means to the owner, what it would cost to start from scratch, or what a similar company sold for in another state five years ago.

Many small businesses that change hands in Texas are bought by individuals or small companies, and many of those purchases are financed in part with bank or SBA loans. That makes the lender a second audience for any valuation. A lender underwrites the cash flow the business shows on its tax returns and supporting statements, and it needs that cash flow to cover the buyer's debt payments with room to spare. A price that the earnings cannot support will not be financed, whatever the seller believes it is worth.

Four approaches cover nearly every small business: seller's discretionary earnings, EBITDA, asset based methods, and market comparables. A sound opinion usually starts with one primary method and uses the others to test it.

Seller's discretionary earnings

Seller's discretionary earnings, or SDE, is the total financial benefit the business produces for one full time owner operator. It starts with pretax net income from the tax return or financial statements and adds back items that are either noncash, financing related, discretionary to the current owner, or not expected to recur. The result shows a buyer what the business would have produced for them if they had owned it during the same period.

SDE is the standard measure for owner operated businesses: trades and home services, restaurants, retail, personal services, and small professional practices. A buyer applies a multiple to SDE that reflects the risk of the business, and that multiple comes from the market for comparable businesses, not from a formula.

Standard add backs

Why add backs must be documented

An add back increases SDE, so every one of them increases the implied price. Buyers, their accountants, and lenders know this, and they test each one. An add back backed by invoices, bank statements, payroll records, or a clear entry on the general ledger usually survives diligence. An add back supported only by the owner's memory usually does not.

Unsupported add backs cause a predictable problem. The buyer agrees to a price based on the seller's SDE, the lender or the buyer's CPA removes the add backs that cannot be proven, and the deal is either repriced or lost. Documenting add backs before going to market avoids that. Cash income that was not reported on tax returns is a separate issue: buyers and lenders generally will not credit it, and it should be discussed with your CPA rather than presented as an add back.

EBITDA multiples

EBITDA is earnings before interest, taxes, depreciation, and amortization. For valuation it is normalized in the same way as SDE, with nonrecurring and personal items removed, but with one important difference: the cost of management stays in. If the owner works in the business, EBITDA deducts a market rate salary for the role, because a buyer would have to pay someone to do it.

EBITDA becomes the primary measure when the business is large enough to have a management team in place and the buyer is likely to be an investor or another company rather than an owner operator. Private equity firms, family offices, and strategic acquirers typically price on EBITDA because they do not plan to run the business themselves. Using SDE for a business of that size, or EBITDA for a small owner operated shop, gives a misleading result, so the choice of earnings measure is one of the first decisions in any opinion.

Asset based approaches

Asset based methods value the business by what it owns rather than what it earns. They matter most for businesses whose earnings are thin compared with their assets, and as a floor for any business with significant equipment, vehicles, inventory, or real property.

Adjusted net asset value

The book value on a balance sheet reflects historical cost less depreciation, which rarely matches what the assets are worth today. Adjusted net asset value restates each asset and liability to current fair market value. Equipment is restated to what it would cost to buy in similar condition, inventory to what is saleable, and receivables to what is collectible.

Liquidation value

Liquidation value estimates what the assets would bring if the business closed and they were sold, either in an orderly sale over time or in a forced sale. It is the lowest reference point and is relevant when a business is not profitable enough to sell as a going concern, or when an owner is weighing a sale against closing.

Market comparables

The market approach looks at what buyers have paid for similar businesses. For private companies the data comes from subscription transaction databases that collect reported sales of privately held businesses, including price, revenue, earnings, and deal terms. The comparison is usually expressed as a ratio of price to SDE, EBITDA, or revenue for businesses in the same industry and size range.

Comparable data has limits. Reported sales vary in quality, earnings definitions differ between sources, and two businesses with the same code can operate very differently. The data gives a range, and the factors in the next section decide where in that range a specific business falls.

Why public company multiples do not transfer

Owners sometimes see valuation ratios for publicly traded companies in their industry and assume the same ratio applies to them. It generally does not. Public companies are far larger, serve many customers and markets, have management teams that do not depend on a founder, and have shares that can be sold any trading day. A small private business carries more risk on each of those points, and its ownership cannot be sold quickly. Buyers price that difference, which is why private transaction data is the relevant reference.

The factors that move value up or down

Two businesses with the same earnings can sell for very different prices. The difference comes from how confident a buyer and a lender are that the earnings will continue under a new owner. These are the factors we review in every opinion.

Many of these factors can be improved before a sale. Delegating customer relationships, putting service agreements in writing, extending a lease, and cleaning up the books all take time, which is one reason to get an opinion of value well before you plan to list. Our guide on how to sell a business covers preparation in more detail.

Our small business valuation services: The broker opinion of value

Forge provides small business valuation services in the form of a broker opinion of value. It is the estimate a business broker prepares to show where a business is likely to price in the current market, based on its financial records and on the factors buyers and lenders weigh.

What you provide

• Business tax returns for the last three years
• Profit and loss statements and balance sheets for the same years, plus the current year to date
• A list of proposed add backs with supporting records
• An equipment and asset list, with approximate age and condition
• The current lease and any amendments
• A short description of staff, customers, suppliers, and how the business runs day to day

What the opinion includes

• A recast of earnings showing each add back and its support
• The earnings measure used, SDE or EBITDA, and why
• A market based price range with the reasoning behind it, cross checked against asset value
• The strengths and risks a buyer or lender is likely to raise
• Specific steps that could improve how the business presents to buyers

How owners use it

The most common use is pricing a sale: setting an asking price that the earnings can support and that a lender can finance. Owners also use an opinion of value for planning, to decide whether to sell now or work on the business first, and for discussions between partners about a buyout. When an opinion is used between partners, each side should have its own advisors, and a binding buyout under a partnership agreement may call for a certified appraisal.

If you decide to sell, the opinion becomes the starting point for the listing. Owners who want to understand how a broker markets a business across the state can read about our Texas business brokerage work.

When you need a certified appraisal instead

A certified appraisal is a formal valuation prepared by a credentialed business appraiser under recognized professional standards. Credentials in the field include the Accredited Senior Appraiser designation from the American Society of Appraisers, Accredited in Business Valuation from the AICPA, and Certified Valuation Analyst from NACVA. Situations that commonly call for one include:

• SBA lending. On some SBA loans used to buy a business, the lender is required to obtain an independent business valuation from a qualified source. Whether one is required depends on the loan and on current SBA rules, and the lender orders it.
• Estate and gift tax. Transfers of business interests reported to the IRS are typically supported by a qualified appraisal.
• Litigation. Shareholder disputes, damages claims, and other court matters rely on valuation experts who can testify to their methods.
• Divorce. Dividing a business interest in a divorce typically requires a valuation that will hold up in court.
• ESOPs. Employee stock ownership plans must use an independent appraiser to value the company stock.

Each of these requires a credentialed appraiser. Forge does not provide certified appraisals. If your purpose falls into one of these categories, we will tell you so and recommend that you engage an appraiser, your attorney, and your CPA.