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This discussion is focused on the valuation of a smaller or lower
middle market business.

There are no simple formulas that will accurately establish the value of a business.  Hundreds of factors can affect the fair market value of any business, including those in the following areas and more:

  • Conditions in the general economy

  • Conditions in the debt, equity and foreign exchange markets

  • Availability and cost of investment capital

  • The “market psychology”, that is, is the emotional mood in the investments markets positive or negative.

  • Market and competitive conditions in the industry and geographic area of the business

  • Ease of entry or exit into the business

  • The business’s historical financial and operational performance

  • Condition and transferability of the key tangible and intangible assets of the business

  • The business’s dependence on the owner and strength of management team

  • Relationship with and dependence on key customers and suppliers

  • Ongoing business and growth opportunities

  • Environmental risks

  • Etc.

Moreover, the most probable selling price for any business can be dramatically different from the fair market value, depending on

  • Potential synergies with specific potential buyers

  • Seller motivation and urgency

  • Buyer motivation, perception and urgency.

The investment value is what the business is worth to a specific buyer, and reflects anticipated synergies.  If potential synergies are high, the investment value can be dramatically different from fair market value.  Failure to accurately estimate the investment value and potential synergies can lead to extraordinary costly mistakes. 

Discounted Cash Flow

The fundamental value of any investment asset its discounted cash flow which is the sum of the future stream of cash flow discounted to the present time using a discount rate.   The short hand version of this often used by the market is to multiply the current cash flow of the business times some multiplier, where the multiplier represents what the market (or other buyers) are paying for similar businesses.  This multiplier is a short hand for perceived risk and opportunity.

Business Value

Four key value factors are:

  • Business Cash Flow

  • Risk

  • Desirability/ strategic value

  • Terms of Sale

Business Cash Flow

The most important driver of business value is its cash flow.  Generally, the market looks at Operating Cash Flow or Free

Cash Flow.

Operating Cash Flow for small privately owned business is called Seller’s Discretionary Earnings (“SDE”) or Owner’s Cash Flow, etc., while for larger business it is called Earnings Before Interest, Taxes, Depreciation & Amortization (“EBITDA”).  The key difference is that many owners of small privately owned business run a lot personal expenses through the business, while most larger business do less of this.  Even for these larger business we generally have to adjust the earnings or cash flow for “discretionary” items to get a true picture of the cash flow of the business. 

The International Business Brokers Association standardized the process of looking at small business cash flow and they define Seller’s Discretionary Earnings as the financial benefits accruing to the owner of a business.  The formula for calculating SDE is:

  • Pre-Tax Net Income, plus

  • Compensation (salary, bonus, etc., but not including “distributions” which is a return of capital not earnings) paid to one owner, plus

  • Non-Operating Expenses like Interest, plus

  • Non-Cash Expenses like Depreciation and Amortization, plus

  • Discretionary Expenses (auto, medical insurance, life insurance, club memberships, non-business travel and meals and entertaining and non-working family members either not on the payroll or paid above market compensation), plus or minus

  • Extraordinary or One-Time expenses like a big non-recurring sale (minus) or expenses related to a hurricane, unusual lawsuit, and physical move of the business, etc. (plus) equals:

Seller’s Discretionary Earnings (SDE), or Adjusted EBITDA

The source and quality of this financial data is important.  The business must be able to prove to a buyer or his bank that the data is correct and complete and that any adjustments realistically reflect the real cash flow of the business.  Many banks, for example, will not include “add-backs” which they feel are far-fetched.

A big difference between SDE and EBITDA is that the latter is used for larger business, for example ones with cash flow in excess of $1 million.  In this case a buyer often times will look at the business more as an investment than as a business to run himself, that is, the owner will be a passive investor and not an “owner-operator”.  In this case, he will adjust the cash flow by removing the compensation and other perks that the current owner pays himself and replaces them with what he believes the market value total cost (comp plus perks) of a professional manager would be to arrive at a cash flow that he will receive as the new owner.  That is:

Adjusted EBITDA=SDE – (annual total cost for a manager capable of running the business).

Free Cash Flow

An additional way of looking at cash flow is to evaluate how much additional cash the business owner will have to invest in the business after he buys it for working capital (current assets minus current liabilities) and capital investments.  If the business requires lots of working capital and new capital investment the buyer will normally adjust Cash Flow by this need for more investment.   Therefore Free Cash Flow is generally calculated as EBITDA less cash needs for Working Capital and Capital Investment.


Obviously a buyer will value a business with high perceived risk less than one with low perceived risk.   Risk will have a dramatic impact on perceived value.  Some key risk drivers follow.

  • Tenure of the Business

The longer the better since it will have a longer history of cash flow and a level of goodwill with customers

  • Quality of books and records

If the books and records, especially the tax returns, are clean, complete, accurate, consistent and fairly represent the business, after detailed due diligence by the buyer or his accountant and other advisors, the business has less risk that therefore more value.

  • Trends

If revenue, profits and general economic and market conditions are trending up the business is more valuable and vice versa.

  • Cyclicality

Businesses which have large swings in demand are generally less valuable because they are perceived to have more risk.

  • Strength of Goodwill

A business with excellent customer awareness and preference will have excellent goodwill and it this can be effectively conveyed to the buyer will have significant positive impact on risk and value.

  • Competition

A business with no or little competition and where the ability of new competitors to enter the market is low will have less risk for the buyer.

  • Customer and Supplier Concentration

A business with little concentration of customers or suppliers will offer the buyer less risk.  In addition, if future sales and sourcing of purchase goods and services are under contract which can be assigned to the buyer, the buyer will perceive less risk.

  • Physical Plant

If the business has well maintained plant and equipment it will be perceived as having less risk.

  • Property Leases

If the business leases its property, the remaining term and the conditions of the lease will have a material effect on risk and value.  Generally a longer remaining term is positive since the buyer will not be put into a position of having to renegotiate the lease soon after purchase or face moving the business.  In addition, leases have many conditions, some of which are not favorable to the business owner lease.

  • Unionization

A non-union business is considered by most to have less risk

  • Franchises

Depending on which franchise this can either be a positive or negative based on the perception of the franchisor and his historic relationships with franchisees.

  • Dependence on Owner and Management Team

If the business is not overly dependent on the owner for sales, operations, technology, etc. and it has a management and employee team and a developed business model that reduces dependence on the owner, the business will be much more valuable to a buyer because the frequent outcome of a business sale is that the owner leaves and who will provide what he has?  One test is how much vacation does the owner-operator take, more is an indication that he has the team and business model in place to provide value at lower risk.

One outcome of the risk analysis is whether this is a business that a bank will finance.  Banks are very risk adverse and tend not to provide business acquisition lending unless they have a positive feeling about the business.  If a business is “bankable” it is more valuable.  For example, think of the value of a house.  If buyers had to pay 100% cash to purchase the house it most likely would have a significantly lower value than if the buyer could put 20% down and get a bank mortgage for the balance.  Similar logic applies to business value.


Desirability is the flip side of risk.   A more desirable business will sell for a higher price than a less desirable one. Some of the factors that increase desirability include:

  • Size

Bigger is better.  Business with higher revenue and cash flow are generally more desired than smaller business.  In an owner-operator purchase this is especially true but the business will have to provide a source and perhaps the only source of income for he and his family to live on.  In addition, banks have a more positive feeling towards a larger business, therefore, more desirable.

  • Growth

Consistent and forecast high revenue growth is more desirable then no or slow growth.

  • Strategic value

Oftentimes the best buyer of a business is s “strategic buyer” like a competitor, supplier or customer who can see synergistic value in the acquisition of the business because they expect to increase revenues, reduce costs, better utilize existing assets, and desired technology, etc.  This increase in value may be significant but may be offset by the higher risk associated with trying to sell to a competitor.

  • Hours the Owner works

This is similar to owner dependency mentioned above.  The more hours the owner works the less the business value.  For an owner-operator the value he obtains from the business is both a return on his time spent on the business, that is, his salary, plus the return of his invested capital, profits.  Therefore, the more he works the more the cash flow is spent for his salary and less is left for return of capital.   Which of the following business are more valuable?  The two are identical with exactly the same cash flow, except in one the owner works 75 hours per week and take no vacation and in the other the owner works 40 hours per week and takes 4 weeks of vacation.

  • Fun and Glamor

A business that is perceived to be more fun to operate and is more glamorous may or may not be more valuable.  It is all in the eyes of the buyer.

Terms of Sale

The final value factor is the “Terms of sale”, or “deal structure”   This is the result of the negotiation between buyer and seller.

  • Seller Financing

In today’s economy most small business sales include some level of seller financing, that is, the seller provides a loan to the buyer to help finance the deal.  Even if there is bank financing the bank may require the seller to provide at least some amount of financing, say 10%.  Seller financing is both risky and provides some benefits to the seller.  The risk is default of the note.  The benefits include:

getting a higher price, perhaps 10 to 20 % more,

having more prospective buyers who can afford or will be willing to bid on the business since their down payment will be less and their perception of risk is less since the seller will have “skin in the game”

interest income for the life of the loan

opportunity to defer recognition of the taxable gain until future periods

  • Deal Structure

Most often the sale of a small business is structured as a sale of business assets with the assumption of no liabilities.  This is generally preferred by the buyer because of the risk of contingent liabilities and the more favorable tax treatment the buyer may receive in an asset sale.  However, this asset sale structure may cause the seller to pay more income taxes.  One alternative is to make the transaction a sale of securities.  

  • Purchase Price Allocation

The IRS requires buyers and sellers to agree in writing on the Purchase Price Allocation for an asset sale.  This is an allocation of the purchase price into several assets categories like fixed assets, covenant not to compete, goodwill, etc.  This allocation will have tax implications for both buyer and seller therefore, after getting good advice from their tax advisor sellers can often negotiate this to their advantage since the real value to a seller is the after tax value of the deal.

Valuing Your Business

The only real value of a business is what price and other terms and conditions of a deal that a real seller and a real buyer agree to.

Therefore, a seller going to market needs to position his offering in a way that provides him the best chance of getting the best overall deal.  This is one of our strengths.  We work with sellers to help them position, package, market and negotiate the best deal for them with the lease hassle and the fastest period of time.   Part of this process may include our recommendation the business owner get a business valuation from an independent third party qualified appraiser. 



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