How to Value a Small Business (SDE and Multiples)

Why Earnings Drive the Price

A buyer is really buying a stream of future cash. The building, trucks and inventory matter, but what sets the price is how much money the business reliably puts in an owner's pocket.

That is why most valuations of owner-run companies start with one number: seller's discretionary earnings, or SDE. Get that number right and the rest of the math is fairly simple.

Step 1: Start With Net Profit

Pull your profit and loss statements for the last three years, plus the current year to date. Tax returns work too, and buyers will eventually compare the two, so they should tell the same story.

Start with net profit before income taxes. This is the bottom line before any adjustments. For many owners, it looks low, because the books were kept to keep taxes down.

Step 2: Add Back the Owner's Pay

SDE assumes one full-time owner-operator. So you add back the salary, payroll taxes and benefits you pay yourself. A buyer will step into that role and decide how to pay themselves.

If two owners work in the business, usually only one owner's pay gets added back. The second person's job still has to be done by someone, and a buyer will need to pay for it.

Step 3: Add Back Interest, Depreciation and Amortization

Interest depends on how you financed the business, not on how it runs. A buyer will bring their own financing, so interest expense is added back.

Depreciation and amortization are accounting entries, not cash leaving the business that year. They get added back too, though a smart buyer will still ask about future equipment needs.

Step 4: Add Back Personal and One-Time Expenses

This is where most of the debate happens. Add-backs are costs that ran through the business but won't continue under a new owner. Common examples include:

• A personal vehicle, phone or travel paid by the company
• Family members on payroll who don't actually work there
• A one-time legal bill, lawsuit settlement or move
• Rent above market, when you own the building and charge the business extra
• Charitable donations and personal insurance policies

Every add-back needs proof. Receipts, statements and a short note explaining each one go a long way. An add-back you can't document will likely get thrown out during due diligence.

Be honest about what is truly one-time. A buyer will notice a "one-time" repair that shows up every year, and it costs you credibility on the rest of your numbers.

A Simple Worked Example

The numbers below are made up for illustration only. They describe a fictional service company, not a real business or a real sale.

• Net profit before taxes: $180,000
• Owner's salary and payroll taxes: $120,000
• Interest on equipment loans: $15,000
• Depreciation: $40,000
• Owner's truck and personal phone: $12,000
• One-time legal settlement: $8,000

Add it up and this example company has SDE of $375,000. If buyers in its industry paid around 2.5 times SDE, the business might be priced near $937,500 before terms and working capital are settled.

Again, that multiple is only an example. Real multiples depend on industry, size and risk, and they move with lending conditions and buyer demand.

Step 5: Weight the Years

One great year doesn't set the price. Buyers look at the trend. Rising earnings over three years make a strong case, while a sharp spike or drop invites hard questions.

Some valuations use a weighted average that counts the most recent year more heavily. Others use trailing twelve months. Either way, steady results usually earn more trust than a single peak.

When EBITDA Replaces SDE

As companies grow, the owner usually stops doing the daily work. A general manager runs operations, and the buyer may be a private equity group or a larger competitor, not a hands-on owner.

At that point, valuations shift to EBITDA: earnings before interest, taxes, depreciation and amortization. The key difference is that EBITDA treats a fair market salary for the manager as a real cost.

There is no exact cutoff. Larger companies, especially those with a manager in place, tend to be priced on EBITDA, and the multiples applied to EBITDA are usually higher than SDE multiples.

Buyers at that size often order a quality of earnings report, where an outside accounting firm tests your add-backs and revenue. Clean books make that step far less painful.

What Moves the Multiple

Two companies with the same earnings can sell for very different prices. The multiple reflects how risky those earnings look and how likely they are to grow. Things that tend to raise it:

• Recurring revenue, such as service agreements or maintenance contracts
• No single customer making up a large share of sales
• A team and manager who can run things without the owner
• Clean, accurate books that match the tax returns
• A transferable lease, current equipment and documented processes
• Steady growth over several years

Things that pull it down are mostly the reverse: an owner who holds every key relationship, a short lease, aging equipment, or a big customer who could walk away after the sale.

Industry matters as well. Trades like HVAC with steady service work draw a lot of interest, while businesses tied to one contract or one season tend to see more caution from buyers.

Other Valuation Methods

The earnings multiple is the main tool, but appraisers and brokers often check it against other approaches:

• Asset-based value, which looks at equipment, inventory and property, and works as a floor for asset-heavy companies
• Discounted cash flow, which projects future earnings and discounts them back to today, more common in larger deals
• Comparable sales, which look at what similar businesses actually sold for

When the methods land in roughly the same range, you can trust the number more. When they disagree, the gap usually points to something worth fixing or explaining.

What Your Number Doesn't Include

A valuation gives you an enterprise price. What you actually take home depends on debt payoff, broker and legal fees, taxes and how the deal is structured, such as a seller note or earnout.

Working capital is another common surprise. Many deals expect a normal level of receivables and inventory to stay with the business at closing, which can change your final check.

Getting Started

Doing the math yourself is a good start, but a second set of eyes catches add-backs you missed and ones a buyer won't accept. Our business valuation page explains how ours works.

Request a free, confidential valuation, or call (317) 555-0186. If you're still a few years out, exit planning can help raise the multiple first.