How to value a business.

What "valuation" actually means

There is no single number. A defensible business valuation is a range, anchored by an earnings methodology and adjusted for the specific risks of the business.

Business valuation is the process of estimating what a willing buyer would pay a willing seller for a business, in an arm's-length transaction, with both parties having reasonable knowledge of the relevant facts. That's the textbook definition. In practice, it's a process of building an evidence-based case for a number that a real buyer will actually agree to.

The most common mistake is treating valuation as a single point — "my business is worth $2.4M." The right framing is a range: low, mid, and high, with explicit assumptions behind each. Buyers do this work too. The deal happens where the seller's defensible range overlaps with the buyer's.

SDE vs. EBITDA — which to use

SDE for businesses where the owner is the operator. EBITDA for businesses with professional management. The line falls somewhere around $2M to $3M in sale value.

Seller's Discretionary Earnings (SDE) is the total financial benefit an owner-operator receives from the business. It starts with net income, then adds back owner salary, interest, taxes, depreciation, amortization, and discretionary expenses (the owner's car, family member salaries above market, club memberships, and so on).

SDE is the right metric when the business is run by one owner who is also the primary operator. Buyers in this range — typically individual buyers or first-time ETA buyers — are evaluating the business as a job replacement plus a return on capital. SDE captures both.

Adjusted EBITDA is earnings before interest, taxes, depreciation, and amortization, plus one-time and non-operating add-backs (legal settlements, owner-discretionary expenses normalized to market rates, anomalous bad debt write-offs, and so on). Critically, EBITDA does not add back the cost of replacement management. If the owner is paid $80K below market, EBITDA leaves that gap there.

EBITDA is the right metric when the business has professional management in place (or could plausibly be run with hired management). Buyers at this size — private equity, family offices, larger search funds — are evaluating the business as a standalone operating asset.

Industry multiples and what drives them

Multiples vary by industry and by deal size. A 3x SDE multiple in HVAC means something different from a 3x SDE multiple in restaurants.

Once you have your earnings number (SDE or EBITDA), valuation comes from applying a market-derived multiple. Multiples reflect three things: industry, deal size, and risk.

These are illustrative ranges. The actual multiple a specific business commands depends on customer concentration, recurring revenue percentage, growth trend, owner involvement level, geographic diversity, contracts in place, and the quality of the management team.

Add-backs: what counts, what doesn't

Add-backs are the difference between reported earnings and economic earnings. Get them right and you defend a higher multiple. Get them wrong and you signal to buyers that your financials are unreliable.

An add-back is an expense recorded in your P&L that doesn't represent the actual operating cost of the business under new ownership. Common defensible add-backs include:

• Owner compensation above market. If you pay yourself $250K and the market rate for a GM in your business is $130K, the $120K delta is an add-back.
• Personal vehicle costs. The truck or car expensed through the business that you would otherwise own personally.
• Family member compensation above market. A spouse on payroll for $80K when the market rate for the role is $40K.
• One-time professional fees. Legal fees for a specific lawsuit, accounting fees for a one-time IRS audit, consulting on a project that won't recur.
• One-time capital expenditures expensed. A piece of equipment expensed in error that should have been capitalized.
• Personal travel and entertainment. Expenses run through the business that are personal in nature.

What is not a defensible add-back:

• "What I would pay myself if I were the buyer." The add-back is the difference between what you pay and market — not the difference between what you pay and what you wish.
• Marketing or advertising expense. These are operating costs.
• Employee wages, even if you think you could run leaner.
• Rent, even if you own the building. (Rent is a separate analysis — see normalization.)

Risk factor adjustments

The multiple changes based on the risk profile. A business with 60% customer concentration sells for a lower multiple than an otherwise identical business with 5% concentration.

After establishing a baseline multiple from industry and size, sophisticated buyers adjust up or down for specific risk factors. The five that move the needle most:

1. Customer concentration. Any single customer over 20% of revenue is a concern. Over 40% can move the multiple down by a full turn or more.
2. Owner dependence. If the business loses 40% of its value when you leave, the multiple reflects that. Buyers want to see operational depth.
3. Recurring revenue percentage. Contract-based or subscription revenue is worth more per dollar than project-based revenue.
4. Growth trend. A business growing at 15%+ annually trades at a premium. A flat or declining business trades at a discount.
5. Industry tailwinds vs headwinds. A business in a structurally growing market is worth more than the same business in a contracting one.

Other valuation methods (asset, income, market)

The three formal valuation approaches are market, income, and asset. Sophisticated valuations triangulate across all three.

Market approach. What is the business worth based on what comparable businesses recently sold for? This is essentially the multiple-based approach we've been describing.

Income approach. What is the business worth based on the future cash flows it will generate, discounted to present value? Most rigorous in theory, hardest to defend in practice for small businesses. DCF is the standard form.

Asset approach. What is the business worth based on the value of its tangible and intangible assets? Most relevant for asset-heavy businesses, real estate holding companies, or distressed businesses where ongoing operations don't add value.

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

Common owner mistakes

1. Confusing revenue with value. "I do $4M in revenue" does not mean the business is worth $4M. Value is based on earnings, not revenue.
2. Inflating add-backs. Sophisticated buyers reject aggressive add-backs and lose trust in the entire financial presentation.
3. Pricing off the asking price. "My friend sold his business for 5x and mine is bigger" is not a valuation methodology.
4. Ignoring deal structure. A $3M all-cash deal at close is different from a $3.5M deal with $1M in seller financing. Total deal value matters less than what hits the wire.
5. Waiting until you're ready to sell. The valuation work that matters happens 2 to 5 years before listing, not 2 to 5 months before.

Frequently asked questions