Valuing a very small business typically involves multiplying the Seller’s Discretionary Earnings (SDE) by a factor of 1.5 to 3+, or using a percentage of annual revenue (often 0.5x to 1x), depending on industry and profitability. The most common method for small businesses is the SDE approach, which adds back owner salary, non-essential expenses, and one-time costs to net profit to determine the true, total cash flow available to a new owner.
Most of these rules of thumb are based on some multiple of revenue, sales, or earnings. Some are as simple as taking your small business' yearly cash flow and multiplying it by four. For example, if your business generates cash flow of $60,000 per year, it would have a value of $240,000.
for your business to profit. To determine the optimal price, consider buyers' willingness to pay, your necessary profit margin, market conditions, and competitor pricing. The selling price formula is: Selling Price = Cost + Desired Profit Margin.
The most commonly used rule of thumb is simply a percentage of the annual sales, or better yet, the last 12 months of sales/revenues.
12 common valuation mistakes
Service businesses typically sell for 2-3x their annual profit because they often depend heavily on the current owner's relationships and expertise. Manufacturing companies tend to command higher multipliers, often 4-5x their annual profit, due to their tangible assets and established processes.
Revenue/earnings multiple
A more common – and simpler – method of valuing small- and medium-sized businesses uses a multiple of revenue or earnings/EBITDA. This calculation involves taking a company's earnings after all business expenses are paid and using a current industry multiplier to generate a value.
90% of American businesses generate less than $3m in annual revenue, so we'll start there. Companies with under $3m in sales will typically sell for 2.5 – 3.5 X their discretionary earnings (total cash the owner could take out of the company).
Four ways to gauge your business's worth
The most common way to value a business that doesn't have assets is the market-based business valuation model. This finds the business's current market value by comparing it to other similar companies that have sold recently.
If you want real growth, you need room to experiment, and that means accepting the possibility of failure. David Manela explains that successful companies invest roughly 70% of resources into proven strategies and reserve about 30% for testing new ideas.
In most industries, 30% is a very high net profit margin. Companies with a profit margin of 20% generally show strong financial health. If this metric drops to around 5% or lower, most businesses will need to make changes to remain sustainable.
A common rule of thumb is that 20% is a good net profit margin. 10% is fine and likely sustainable, and going too much below this can be risky. But because this can vary wildly by industry, it's best to try to benchmark your profit margins against similar businesses.
Calculate the total Cost of Goods Sold (COGS). Determine your desired profit margin. Use the formula: Selling Price = COGS + (COGS * Desired Profit Margin). Evaluate market demand and competitive pricing.
High-end items (e.g., watches, cars, yachts) can have valuations manipulated through fictitious invoices or staged private sales. Criminals artificially raise or lower reported prices, disguising illicit proceeds as legitimate gains or concealing true wealth.
If your business has achieved $1MM in revenue, congratulations on beating the odds (estimated by the SBA), which say that 30% of small businesses fail within the first year, 50% within five years and 66% during the first ten.