“Price is what you pay. Value is what you get.” Warren Buffett said that.
Buffett was talking about public companies, of course, but his maxim applies equally to purchases of small and closely-held business. Generally speaking, the lower the price, the better the value—if a buyer does their diligence, and assuming no fraud.
At its core, a business’s valuation is simply an informed estimate of what a company should sell for. It’s not a single magic number, though. Instead, it’s a blend of different approaches that, taken together, gives a buyer a clearer picture of value.
Why valuation matters to buyers
Valuation isn’t just about coming up with a purchase price. It shapes how deals are structured and financed, and how buyers (and their investors, and lenders) think about risk. A solid valuation affords leverage in negotiations and helps buyers avoid overpaying. It can also be the difference between getting a loan denied or approved.
The building blocks of value
Buyers should give due consideration to both the quantitative and qualitative aspects of a business.
First come hard numbers: financial statements, tax returns, and key contracts. These reveal how money moves through the business, whether it’s been consistent over time, and which way things are trending. Hopefully, your seller has kept good books and records (not always the case with smaller businesses).
Second, you’ve got the squishier, but equally important, stuff: brand reputation, customer loyalty, intellectual property, and—if applicable—the regulatory environment for the business. Even with a less organized seller, these metrics may be easier for a buyer to ascertain.
Note: two businesses might look identical on paper, but the one with a stronger brand or better customer relationships could fetch a significantly higher price.
How professionals value a business
There are a few common ways to value a business, and you may see more than one used in a buy-sell transaction.
The asset-based approach looks at what the business owns minus what it owes. This is most useful for asset-heavy businesses or situations where liquidation is a real possibility. For service-based businesses, throw this one out the window.
The market-based approach compares the business to similar ones that have recently sold. It’s like looking at comparable homes when buying real estate, except the data can be harder to find and less reliable.
The income-based approach focuses on what the business is expected to earn in the future. This is where things get interesting, because it forces you to think about growth, risk, and how much you’re willing to pay for future cash flow.
Three metrics you need to know: SDE, cash flow and EBITDA
If you’re shopping for a small or closely-held business, you’ll hear a lot about three specific metrics: seller’s discretionary earnings (SDE), cash flow and EBITDA. Of these, SDE and cash flow are closely related and sometimes used interchangeably in small businesses deals.
Many businesses marketed through brokerage sites will list a sales price based on one of these metrics. Understanding the difference between them and when each applies is critical to help assess whether a business is priced correctly.
Seller’s Discretionary Earnings
SDE is all about the owner-operator. It measures how much cash flow is available to an owner who runs the business full-time (sometimes termed “free cash flow”). To find SDE, you start with net income and add back things like the owner’s salary, depreciation, interest, and any one-time or personal expenses. In plain English, SDE answers the question: “If I buy this business and run it myself, what is the total benefit to me?”
Small businesses valued on SDE typically sell for 2x to 4x earnings, with the exact multiple depending on factors like industry, growth potential, and how dependent the business is on the owner. You’ll generally also see lower multiples for micro-businesses, where the owner’s presence is critical for day-to-day operations. You’ll see higher multiples for businesses with strong, documented systems, recurring revenue, and less owner dependency.
Cash flow
Cash flow is the net amount a business owner pockets each year, whether through distributions/dividends, guaranteed payments/salary or a combination thereof. A simple way to calculate cash flow is to take SDE, then subtract capital expenditures and loan payments. Again, this term is often used interchangeably with SDE in the advertising of small business sales, and it’s important to ask questions to get at a business’s real value (or what you are willing to pay).
EBITDA
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This is a “level up” metric, as it assumes the business will be run by professional management, not a single owner. For EBITDA purposes, a market-rate manager’s salary is treated as a real expense, not something to be added back.
EBITDA is the go-to metric for larger, more scalable businesses—usually those earning more than a million or two annually—and it’s what institutional buyers and private equity firms assess. Because EBITDA-based businesses are generally more stable and more scalable, they tend to sell for higher multiples, often in the 4x to 8x EBITDA range, or even more.
When to use SDE, cash flow and EBITDA
So when do you use which? Generally, if the business is heavily dependent on the owner and does less than $1.5 or $2 million in annual revenue, SDE is probably the right metric. If it can run without the owner and has multiple layers of management, EBITDA is more appropriate. In the middle range, it’s smart to calculate both and see which one makes more sense, given the buyer pool and business model.
One word of caution for buyers: even sellers with pristine books will often inflate these numbers with aggressive “add-backs.” Sellers may claim certain expenses are one-time or personal, but savvy buyers (and lenders) will scrutinize those adjustments. In my experience, it’s not uncommon for a quality-of-earnings review to knock up to 25 percent off a seller’s initial EBITDA figure.
Pro tip: always ask for backup on every add-back, and make sure the business’s normalized cash flows pencil. Otherwise, you are overpaying, and you’re less likely to get a loan, if needed.
The role of advisors
You can get a rough idea of a business’s value using online tools or industry benchmarks, but some situations really do call for a professional. If you’re applying for financing, dealing with complex ownership structures, or heading into a regulated industry, it’s worth working with someone who knows what they’re doing.
Look for a CPA with an Accredited in Business Valuation (ABV) designation, or an appraiser affiliated with the American Society of Appraisers (ASA). Their reports can be invaluable when you’re negotiating a sale price, or defending your position down the line.
Don’t forget intangibles
Some of the most valuable parts of a business don’t show up on a balance sheet. Goodwill, brand recognition, loyal customers, and intellectual property often explain why one business sells for a premium while another doesn’t—even if their financials look similar. As a buyer, you need to dig into these intangibles during diligence. Unlike equipment or inventory, their value can disappear quickly if they’re not properly maintained or transitioned after closing.
What about startups?
Early-stage companies are different, and harder to price. They often lack years of financial history, so traditional metrics like SDE or EBITDA may not apply. Instead, valuation is based more on forecasts, comparable deals, and the strength of the founding team. Investors also weigh factors like intellectual property, technology and market potential.
In start-up sale situations, you’ll often see creative deal structures—earnouts, convertible notes, equity rollovers, etc.—to bridge the gap between what the seller thinks the business is worth and what a buyer is willing to pay.
The bottom line
From a buyer’s perspective, a business’s value usually isn’t a one-time calculation, or something that is set in stone at the start of a transaction. In most deals, it’s a negotiation that evolves as a buyer learns more about the business. Often, this is after the execution of a purchase agreement, or after a deal is structured, which I will cover in my next post.
The more you understand about how value is determined—and the more disciplined you are about challenging assumptions—the better positioned you’ll be to find a business you want to own, and to make a smart acquisition.
