How to Evaluate Business Valuation Methods

"How much should I pay for this business?"

It's the first question every buyer asks. And sellers always think their business is worth more than it is. Here's how professional buyers evaluate whether an asking price is fair—and how to calculate what YOU should actually pay.

## The Problem With "Business Valuations"

Sellers love to get "professional valuations" to justify high asking prices. But here's the truth: a business is only worth what a buyer will pay for it. Professional valuations are often:
- Based on optimistic projections
- Using industry averages that may not apply
- Prepared by valuators hired by the seller
- Not accounting for business-specific risks

**Your job:** Do your own valuation using multiple methods.

## The 5 Methods Professional Buyers Use

### Method 1: EBITDA Multiple

**What It Is:** The most common method—multiply earnings before interest, taxes, depreciation, and amortization by an industry multiple.

**Formula:** Business Value = EBITDA × Industry Multiple

**Example:**
- EBITDA: $250,000
- Industry Multiple: 3.5x
- Value: $875,000

**Industry Multiples (General Guidelines):**
- Service businesses: 2.0-3.5x
- Retail: 2.0-3.0x
- Manufacturing: 3.0-5.0x
- SaaS/Tech: 4.0-8.0x
- Healthcare: 4.0-7.0x

**Critical Adjustment—Calculating True EBITDA:**

Sellers love to "add back" everything to inflate EBITDA:

**Legitimate Add-Backs:**
- Owner salary above market rate
- One-time expenses (lawsuit, major repair)
- Personal expenses in the business
- Non-cash charges (depreciation)

**NOT Legitimate:**
- Marketing "we don't need to do anymore"
- Rent "if you negotiate better terms"
- Maintenance "if you do it yourself"
- Future growth you might achieve

**Example Calculation:**
```
Net Income (from tax return): $180,000
+ Owner salary: $120,000
- Market-rate manager: -$70,000
+ Depreciation: $25,000
+ One-time legal fees: $15,000
= Adjusted EBITDA: $270,000

× Industry Multiple (3.0x):
= Fair Market Value: $810,000
```

### Method 2: Seller's Discretionary Earnings (SDE)

**What It Is:** Used for smaller businesses where owner is heavily involved. Measures total financial benefit to a working owner.

**Formula:** SDE = Net Income + Owner Compensation + Interest + Depreciation + Amortization + One-Time Expenses

**SDE Multiples (Generally Lower):**
- Small businesses: 2.0-3.0x SDE
- Very small (under $500k revenue): 1.5-2.5x SDE

**When to Use:** For businesses under $1M in revenue where you'll be the owner-operator.

**Example:**
```
Net Income: $85,000
+ Owner salary & benefits: $90,000
+ Owner's personal expenses: $12,000
+ Interest: $5,000
+ Depreciation: $8,000
= SDE: $200,000

× Multiple (2.5x):
= Value: $500,000
```

### Method 3: Asset-Based Valuation

**What It Is:** What could you liquidate the business for? Minimum value floor.

**Formula:** Total Assets - Total Liabilities = Net Asset Value

**When to Use:**
- Struggling businesses
- Asset-heavy operations (manufacturing, retail with inventory)
- When earnings don't justify a multiple

**How to Calculate:**
```
Equipment (fair market value): $150,000
Inventory (actual sellable): $75,000
Accounts Receivable (collectible): $45,000
Real Estate (if owned): $300,000
Total Assets: $570,000

- Accounts Payable: -$35,000
- Loans: -$120,000
Total Liabilities: -$155,000

Net Asset Value: $415,000
```

**Important:** This is usually the MINIMUM value. If earnings multiples give you a lower number, use asset value instead.

### Method 4: Revenue Multiple

**What It Is:** Quick and dirty method using a percentage of annual revenue.

**Formula:** Business Value = Annual Revenue × Multiple

**When to Use:** Quick screening, certain industries with standard multiples

**Industry Guidelines:**
- Service businesses: 0.5-1.0x revenue
- Retail/restaurants: 0.3-0.7x revenue
- SaaS (with high retention): 2.0-5.0x revenue
- Professional services: 0.5-1.5x revenue

**Why It's Risky:** Revenue multiples ignore profitability. A $1M revenue business losing money isn't worth $500k.

**Better Use:** As a sanity check against EBITDA multiples.

### Method 5: Comparable Sales

**What It Is:** What did similar businesses actually sell for?

**Where to Find Comps:**
- BizBuySell completed listings
- IBISWorld market research
- Business broker databases
- Industry associations

**What to Compare:**
- Similar industry and size
- Similar geography
- Similar business model
- Sold within last 2 years

**Adjustments Needed:**
- Size differences (larger = higher multiple)
- Growth trajectory
- Customer concentration
- Market position

## The Valuation Framework: Putting It All Together

**Step 1: Calculate Multiple Values**
```
EBITDA Method: $810,000
SDE Method: $780,000
Asset Method: $415,000
Revenue Method: $650,000
Comparable Sales: $750,000
```

**Step 2: Weight the Methods**

Different situations call for different weights:

**For Established, Profitable Business:**
- EBITDA method: 50%
- Comparable sales: 30%
- Asset value: 20%

**For Owner-Operated Small Business:**
- SDE method: 50%
- Comparable sales: 30%
- Asset value: 20%

**For Struggling Business:**
- Asset value: 60%
- Revenue method: 20%
- EBITDA method: 20%

**Step 3: Apply Risk Adjustments**

Reduce value for:
- Customer concentration (10-30%)
- Owner dependence (10-20%)
- Declining revenue (20-40%)
- Lease expiring soon (10-30%)
- Key employee risk (5-15%)
- Industry decline (10-30%)

**Example Risk Adjustment:**
```
Weighted Value: $780,000
- Customer concentration (20%): -$156,000
- Owner dependence (10%): -$78,000
Adjusted Fair Value: $546,000
```

## Real Example: Evaluating an Asking Price

**Business Details:**
- Retail store, 15 years old
- Revenue: $1.2M annually
- EBITDA (adjusted): $220,000
- Asking Price: $800,000

**Your Analysis:**

**1. EBITDA Method:**
```
EBITDA: $220,000
× Industry Multiple (2.5x for retail):
= $550,000
```

**2. Revenue Method:**
```
Revenue: $1.2M
× Retail Multiple (0.5x):
= $600,000
```

**3. Asset Value:**
```
Inventory: $180,000
Equipment: $60,000
Less Debt: -$40,000
= $200,000 (floor value)
```

**4. Comparable Sales:**
- Similar store sold for 2.8x EBITDA = $616,000

**5. Weighted Valuation:**
```
EBITDA (50%): $550,000 × 0.5 = $275,000
Comps (30%): $616,000 × 0.3 = $185,000
Assets (20%): $200,000 × 0.2 = $40,000
= Fair Value: $500,000
```

**6. Risk Adjustments:**
- Lease expires in 18 months: -10% = -$50,000
- Owner very involved: -10% = -$50,000

**Your Offer: $400,000-$450,000**

**Seller's Asking Price: $800,000 (80% overvalued!)**

## Common Seller Tricks to Watch For

### Trick #1: "This business could do $X with better marketing"
**Response:** "Great! Do it, then come back when it's performing there. I'm buying today's results, not tomorrow's potential."

### Trick #2: "I'm using a 4x multiple because that's what my buddy got"
**Response:** "Every business is different. What's the justification for that multiple in YOUR business?"

### Trick #3: "The valuation report says it's worth $Y"
**Response:** "Who paid for that valuation? Let me do my own analysis."

### Trick #4: "Another buyer is offering $Z"
**Response:** "Then take that offer. I'm comfortable with my valuation and won't overpay."

## When to Walk Away on Price

Walk away if:
- ✗ Asking price is 30%+ above your valuation
- ✗ Seller won't negotiate reasonably
- ✗ Price only makes sense with best-case growth
- ✗ You'd have negative cash flow at asking price
- ✗ You feel pressured to pay more than it's worth

**Remember:** There will always be another business to buy.

## Negotiation Strategy

**Never lead with your highest offer:**

**Your Valuation: $500,000**

**Negotiation Range:**
- Initial offer: $400,000 (80% of value)
- Walkaway point: $525,000 (105% of value)
- Target: $475,000 (95% of value)

**Structure matters too:**
- All cash = lower price
- Seller financing = slight premium okay
- Earn-out based on performance = protect yourself

## Tools to Help You

**1. Business Valuation Calculator Template**
- Input financials
- Automatic calculations
- Multiple methods
- Risk adjustments

**2. Comparable Sales Research**
- Access to sold comps
- Industry multiples
- Market trends

**3. Financial Analysis Template**
- Organize all financial data
- Calculate adjusted EBITDA
- Trend analysis

## Your Action Plan

**Before Making an Offer:**

1. **Calculate value using 3+ methods**
2. **Apply risk adjustments for specific issues**
3. **Research comparable sales**
4. **Determine your walkaway number**
5. **Structure your offer strategically**

**During Negotiations:**

1. **Be prepared to justify your valuation**
2. **Don't get emotional**
3. **Have alternatives ready**
4. **Know when to walk away**

## The Bottom Line

Most sellers overprice their businesses by 30-50%. Your job is to:
- Calculate fair value objectively
- Identify and adjust for risks
- Negotiate from a position of knowledge
- Walk away if you can't get a fair price

**Don't overpay just because you're excited.** There are thousands of businesses for sale. Take your time, do the math, and only buy at a fair price.

## Get the Tools You Need

- **Business Valuation Calculator:** Calculate fair value in minutes
- **Financial Analysis Template:** Organize and analyze all financial data
- **Complete Due Diligence Guide:** Step-by-step valuation and negotiation strategies

The difference between overpaying and getting a fair price could be hundreds of thousands of dollars. Do the math before you commit.