How to value a small business.

Why valuation methodology matters

Without a methodology, your number is a guess. With a methodology, your number is a defensible position.

The valuation question is the most consequential question an owner can ask about their business. Get it wrong by 30 percent and the difference can be six or seven figures. Yet most owners use rules of thumb that have no defensible basis. The methodology described below is what M&A advisors, business appraisers, and sophisticated buyers actually use.

Step 1: Calculate adjusted earnings

Adjusted earnings are what the business actually produces economically — not what shows up on the tax return.

Reported net income understates economic earnings for most small businesses because of legitimate tax minimization, non-market owner compensation, and personal expenses run through the business. The adjusted earnings calculation corrects for all of that.

For SDE: net income + owner compensation + interest + taxes + depreciation + amortization + discretionary add-backs. Full methodology in our SDE guide.

For EBITDA: net income + interest + taxes + depreciation + amortization + one-time and non-operating adjustments. Importantly, EBITDA only adjusts owner compensation to market rate (not zero).

Step 2: Apply an industry multiple

Industry multiples reflect what comparable businesses have actually sold for. They are not opinions, they are observations.

Multiples come from comparable transaction databases. The ranges below are illustrative — actual multiples depend on the specific industry, size band, geography, and timing.

Step 3: Adjust for risk factors

The risk profile determines where in the multiple range a specific business lands.

The four risk factors that matter most:

• Customer concentration. A single customer over 20 percent of revenue triggers concern. Above 40 percent can drop the multiple by a full turn.
• Owner dependence. Demonstrate the business runs without the owner. Documented processes, capable management layer, succession-ready operations.
• Recurring revenue percentage. Higher recurring revenue commands a higher multiple. The premium can be substantial.
• Growth trend. A business growing 15+ percent annually trades at a premium. Flat or declining trades at a discount.

Other valuation methods

For most small businesses, the multiple-of-earnings approach is primary. The other methods are cross-checks.

• Income approach (DCF). Discounted cash flow analysis. Theoretically rigorous, hard to defend for small businesses because of small-number sensitivity and the difficulty of forecasting accurately.
• Asset approach. Sum of asset values. Relevant for asset-heavy businesses, real estate holding companies, or distressed sales where the going concern adds no value.
• Market approach. Multiple-of-earnings, which is what we have been describing.

For most $1M-$5M businesses, market approach is the primary methodology, with income approach as a cross-check and asset approach as a floor.

Common mistakes

1. Pricing off revenue. Revenue multiples are not a methodology.
2. Inflating add-backs. Aggressive add-backs destroy trust during diligence.
3. Pulling multiples from the wrong industry. A plumbing business and a self-storage facility are not comparable.
4. Ignoring deal structure. Headline price minus working capital adjustment minus escrow minus seller note discount equals what actually hits the wire.
5. Using free calculators as final valuations. They are directional, not defensible.

Frequently asked questions