A business owner or prospective seller may want to know the value of their business before deciding to put it on the market; likewise, buyers may wish to calculate the value or compare the asking price of a business they are interested in.
In the case of business owners considering the sale of their business, most business brokers offer a Market Value Analysis, and our firm offers a comprehensive free Business Market Value Analysis to prospective sellers. Buyer’s are frequently left to rely on the information in the CIM (Confidential Information Memorandum) provided by the Seller’s business broker and need a way to calculate the market value of the business and compare it to the asking price.
In either case, the simplest method to calculate business value is the Earnings Multiple method (also known as Market Data Method, Comps, or Discretionary Earnings, DE Multiple, or EBITDA Multiple).
Most business buyers and sellers/owners are somewhat aware of earnings multiples, but few understand how to properly use and apply these multiples to value a business. There are many myths and opinions about what a business is worth and what “the” earnings multiple is. In fact, earnings multiples vary widely by industry as well as by revenue and earnings of the subject business. Multiples for Discretionary Earnings (DE aka SDE or Seller’s Discretionary Earnings) and EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) are different for the same business. DE multiples are lower than EBITDA multiples because with DE you are multiplying a higher earnings number against a lower multiple and with EBITDA you are multiplying a lower earnings number against a higher multiple. DE is includes the Seller’s (officer’s) compensation and EBITDA is modeled as the business being operated by a GM or CEO (on owner’s salary add-back). Ideally, you should get roughly the same value for both approaches. There are no valuation multiples for “net profit” for a small-midsize business and simply applying say a DE multiple to Net Profit will result in a dramatically undervalued figure for the business. Likewise, calculating EBITDA according to GAAP accounting practices will also result in a substantially undervalued calculation.
As explained below, the Net Profit or GAAP EBITDA does not reflect the actual earnings of a small business, thus using it for valuation purposes is meaningless.
While Earnings Multiples seem like a simple method to value a business, which they can be, they must be used correctly and with the right earnings figures to deliver the correct valuation for a business.
Discretionary Earnings vs Net Profit vs Normalized EBITDA
First you need to understand the difference between each earnings type and how to calculate them, then look at how to apply them.
- Net Profit:
This is the starting point for calculating both DE and Normalized EBITDA. When a business broker or valuation analyst refers to Net Profit this is the Net Profit shown on the company tax returns. The Net Profit on the company P&L is often different from the Tax Return Net Profit as a result of changes made by the accountant or CPA at year end which were frequently not reconciled with the internal P&L. The Tax Return Net Profit is the only figure used for valuation purposes (note that SBA lenders and valuation analysts only use the Tax Return Net Profit). - EBITDA:
GAAP EBITDA is simple to calculate. Start with the Net Profit from the Tax Return and add the Interest, Taxes, Depreciation, & Amortization. This is the GAAP EBITDA and for very large businesses this figure is correct.For small businesses, a Normalized EBITDA is used where you must first add back all of the owner’s benefits & compensation and then subtract a replacement salary for the owner at market rate. This would be the salary of a manager to run the business in place of the seller. This is called Normalized EBITDA which is used for small businesses. A simple way to determine Normalized EBITDA is to take the DE and subtract a replacement salary for the owner at market rate. Most SBA lenders use $150,000 as the standard replacement salary to calculate Normalized EBITDA. In some instances for smaller businesses, the lender may opt to use $100,000.
Discretionary Earnings (DE):
DE is the most commonly used valuation multiple and it is also the most complicated figure to calculate. DE basically is EBITDA + owners salary + owner’s benefits & expenses. This sounds simple enough and it would be except that many owners bury these expenses which can make it difficult to verify these figures. One key rule for owner’s expense add-backs is that they MUST be tied to an expense line item on the tax return. If the expense is not shown on the tax return then it cannot be used as an add-back for calculating DE as it was not shown as an expense on the tax return, which is what is used to calculate DE.
There are a number of add-backs SBA lenders will not consider such as owner’s benefits/expenses buried in COGS, expense in office supplies without specific documentation showing they are not business expense, and estimated expenses with no documentation.
Read more about How to Calculate DE and Normalized EBITDA Correctly with examples how to calculate it and more on add-back.
Finding the Right Earnings Multiple to Calculate Business Value
You can get Discretionary Earnings multiples and Business Valuation Reports from BizBuySell and Peercomps. BizBuySell offers valuation reports from $19.95 to $59.95 and Peercomps offers a one time comps search for $49 or a one time business valuation for $99.
The BizBuySell valuation is the simplest to use and the least expensive. While it is good for determining a price range, the downside is that it is not an accurate valuation program. You should only use it for validating a price range and not for determining an exact business value. Note that the comparable sales data in BizBuySell is broker provided, meaning that brokers input this data when a business is sold through BizBuySell. There are thousands of transactions in the database, the problem is that the way brokers record transactions varies widely, making the data less consistent than Peercomps where the data comes directly from the SBA database of closed transactions and the business valuations (appraisals) of those businesses. In either case, it is important to use “comparable” businesses, meaning the same industry and a similar size range in revenue, DE and Normalized EBITDA. Comps vary by industry and company size within the same industry.
The Peercomps valuation is more comprehensive and uses better comparable sales data as their database is from actual closed SBA financed transactions. All SBA loans require an independent (third party) business valuation (appraisal) by a CVA (Certified Business Valuation Analyst). Thus this comparable sales data is more accurate and more consistent than broker provided comps. The downside of Peercomps is that it is much more complicated to use and obtain an accurate valuation. The user should be familiar with valuation methods in order to use Peercomps.
Steps to Finding Earnings Multiple Comparable Sales Data
- In BizBuySell or Peercomps select the Industry-Business Type (e.g. Distribution, Restaurant, Manufacturing, Construction – note that you can select more specific business types)
- Narrow the Gross Sales and Income ranges to values below and above the company’s annual revenue and income. Set a minimum value to eliminate businesses much smaller than the company you are considering and a maximum to eliminate businesses that are much larger.
- You can change the ranges to narrow or expand your results until you have a suitable number of comps (preferably at least 5 to 10 or more. In some cases there may be very few if it is a small niche).
- Now you should have comparable sales multiples for Discretionary Earnings and if you used Peercomps Normalized EBITDA as well. The next step is to apply the multiples
Important Notes:
- PeerComps DE multiples include “normal” inventory, but DO NOT include A/R (Accounts Receivable), Cash, or NWC (Net Working Capital) and also assume that all liabilities are paid off by the Seller at closing.
- Peercomps multiples include “normal” inventory and BizBuySell comps may or may not.
- Normal inventory is the inventory required to operate the business. Excess inventory is not included in the PeerComps earnings multiples.
Applying the Earnings Multiple to Determine Business Value
If you are using the valuation report from BizBuySell or Peercomps you can input the company earnings and revenue to obtain a value based on the Mean or Average Discretionary Earnings multiple. If you elected to obtain comparable sales data only your next step is to multiply the Mean or Average DE multiple to the DE you calculated. This will give you a value based on the Mean or Average multiple.
It is important to note and understand that the figure you just calculated is not an exact figure. The multiple you just used is an average. Thus, half of the businesses in the comps sold for less than that multiple and conversely half sold for more than that figure.
If you are considering a business that is exceptional it may be worth a premium and the average multiple may be on the low side. Likewise, if the business is below average it may be appropriate to apply a discount.
7 Factors that Affect Business Value and Earnings Multiples
- Recent financial performance, e.g. growth in revenue & DE, flat, or declining
- Quality of Financial Data
- Quality of Product or Service
- Competition
- Years Established
- Quality & Experience of Staff
- Infrastructure, Systems, Procedures
- Customer Concentration
- Industry e.g. construction, manufacturing, disctribution, retail, food services, etc. Each industry has very different multiples and buyer demand.
Here is exactly how NWC is treated when using PeerComps multiples:
1. PeerComps “Sale Price” includes Inventory
Unlike some other databases, the “Sale Price” in PeerComps almost always includes a normal level of inventory.
- The Logic: In the small business world (Main Street), it’s hard for a buyer to get a loan if they have to buy the business and then find extra cash to buy the inventory.
- The Result: If you apply a PeerComps multiple (e.g., 3.5x SDE) to your earnings, you have already calculated the value of the business including the inventory. You should not add inventory on top of that price unless there is “excess” inventory beyond what is normal for the industry or company at closing. For example, if a annual purchase was recently completed and inventory is unusually high.
2. PeerComps usually EXCLUDES Accounts Receivable (AR) and Accounts Payable (AP)
This is the “gotcha” in PeerComps data. Most PeerComps transactions are Asset Sales, where:
- The Seller keeps the Cash and the Accounts Receivable (the money customers owe for work already done).
- The Seller pays off all Accounts Payable (the money owed to vendors).
- The Buyer gets the Equipment, Goodwill, and Inventory.
Crucial Point: If you use a PeerComps multiple to set your price, but your LOI says the buyer is taking the AR and AP (a “Full Working Capital” deal), you must adjust the price. If the buyer takes $100k in AR, they should effectively pay $100k more, or the multiple needs to be adjusted. Including A/R and NWC (Net Working Capital) in the purchase price if you used PeerComps multiples will result in a lower than market value offer and could put you at a disadvantage if there are multiple offers being consider.
Comparison: Small Business Valuations with PeerComps vs. M&A GAAP EBITDA Deals
If your deal is larger (usually over $10M in value) and you probably aren’t using PeerComps but are looking at “Middle Market” standards and comps databases such as DealStats. These transactions are very different in both struture and valuation, as well as the Earnings Multiples. See theh examples below:
| Component | PeerComps (SBA/Main Street) | Standard M&A (EBITDA Multiples) |
| Inventory | Included in the multiple price. | Included in the multiple price. |
| Accounts Receivable | Excluded (Seller keeps it and it is not included in the calculated value, but the Buyer may purchase it in addition to the calculated base value) | Included (Buyer takes it). |
| Accounts Payable | Excluded (Seller pays it off at closing). | Included (Buyer assumes it). |
| Cash | Excluded (Cash-free). | Excluded (Cash-free, some may be left in the corp account depending on the NWC (Net Working Capital) calculation.) |
How to handle this in an LOI
If you are using PeerComps data to justify your price in an LOI, you should include a clause that clarifies the “Working Capital” expectations to avoid a “double dip” where the buyer gets the inventory for free and expects you to leave AR behind.
Example LOI Language for a Small Business:
“The Purchase Price of $X.X million is based on a multiple of [SDE/EBITDA] and normal inventory defined here as $Y amount of Inventory. Accounts Receivable and Accounts Payable are to be retained/liquidated by the Seller at closing.”
Summary for your calculation:
- Do NOT “add” inventory to a PeerComps-derived price; it’s already included in the median DE and EBITDA multiple.
- Do add/adjust for AR and AP if the buyer wants to keep them, as the PeerComps multiple likely didn’t account for them. If you want to purchase the A/R then this would be added to the Peercomps calculated value.
- NOTE: SBA lenders will finance the purchase of A/R as long as the DSCR (Debt Service Coverage Ratio) minimum is met.
Example LOI Business Offer Price Terms
It is best to be specific in your LOI as to what is included, what is not included, and the funding.
Some buyers simply state $3 million cash at closing, which implies it is a “cash” deal. What what they really mean is the seller will get $3 million “cash at closing” (true), but what they left out is the fact they are putting $300,000 and obtaining an SBA loan for $2.7 million. This is misleading to the Seller and a professional business broker will spot this immediately and question it. For the buyer, this fails to include a financing contingency and a timeline for the financing. Likewise, if the Seller missed this, it will be an ugly surprise when they find out.
Example of price and terms for a $3 million business (valued at $3 million using Peercomps)
- Total Purchase Price $3,300,000 million including $300,000 of A/R and/or working capital
(Peercomps calucaclated value of $3 million + A/R of $300,000) - Funding; SBA Financing
- $300,000 cash down
- $150,000 Seller Note, X months fully amortized, Y% interest
- $2,850,000 SBA financing from SBA PLP Lender
- SBA Lender LOI or CCL to be provided within 30 days after signing
- All inventory included
- All Liabilities paid off at closing by Seller including A/P
- 45 Day Due Diligence period
- Estimated Closing 75 days after acceptance
- $50,000 deposit at completion of Due Diligence, applied to the Buyer’s down payment
Summary
Earnings Multiples are a convenient and relatively simple way to calculate business values, but as we discussed above, it is not an exact value and more of an average value. If you are buying a business the Business Broker should have a Recast Financial Statement showing the financials from the Seller’s tax returns and all of the add backs to arrive at the Discretionary Earnings. The Broker should also be able to provide you with Comps Data and a Market Value Analysis.
If you are Selling your business we recast your financial statements and prepare a comprehensive Market Value Analysis as part of our initial review of the business to determine the asking price.
