How to value a small or medium-sized business

Valuation · 8 minute read

Most owners ask what multiple their business is worth. It is the wrong first question. The right one is what a buyer would consider the sustainable earnings of the business, because everything else is applied to that number.

Start with maintainable earnings

In an owner-managed company the reported profit is rarely the profit a buyer would inherit. Owner remuneration may be set for tax reasons rather than market rates. Personal costs may sit in the accounts. There may be one-off income, one-off costs, or property rented from a connected party at a rate nobody would agree at arm's length.

Normalising means adjusting for all of that to reach a figure a new owner could reasonably expect to earn. The adjustments have to be evidenced, because the buyer's adviser will test every one of them.

• Owner and family remuneration adjusted to a market rate for the role
• Personal or non-trading expenses removed
• One-off items removed in both directions
• Related-party rent and charges restated to market
• Costs the business will have to bear in future but has not yet, such as a replacement manager

Then choose methods the evidence supports

Three approaches dominate SME valuation, and the right one depends on the business rather than on preference.

Earnings multiple

The most common approach for a profitable trading business. Maintainable EBITDA is multiplied by a factor drawn from comparable transactions, then adjusted for the specific risks of this business. The difficulty in the lower-middle-market is that comparable transaction data is thin and often unreliable, so the multiple carries more judgement than the arithmetic suggests.

Discounted cash flow

Appropriate where future cash flows can be forecast with reasonable confidence — long contracts, a stable subscriber base, or a defined asset life. It is less useful where a forecast is really an aspiration, because a DCF built on an optimistic forecast simply converts optimism into a large number.

Asset-based

Relevant where the value sits in the assets rather than the trading: property, plant, fleet, or a business whose earnings do not justify a premium over net assets. It also sets a practical floor for many businesses.

Why the answer is a range

A single figure implies a precision that does not exist. Two credible buyers can reach different numbers because they will do different things with the business: a trade buyer removing duplicated overhead can pay more than a financial buyer who needs the business to stand alone.

A useful valuation therefore sets out a range, the assumptions at each end, and the factors that would move the answer within it. That is what allows an owner to decide whether to sell now or spend a year addressing the constraints.

What actually moves the number

In our experience the items below have more effect on the final price than the choice of method.

• How much revenue is recurring or contracted, and for how long
• How much of it comes from the largest one or two customers
• Whether the business can run without the owner for a month
• Whether the management accounts reconcile to the statutory accounts
• Whether contracts, licences and corporate records are complete and findable

Each of these is examined in our Business Risk & Value Framework, and each is at least partly within an owner's control if there is time before a sale.