Before I explain how to value a small business, it’s important to define what a small business is.

The definition of a small business depends on who you speak with or who’s defining it, but for the purpose of buying a small business, I’d define it as a business with sales of less than $10 million dollars or pounds, but ideally a business with sales of between $1 to $5 million dollars or pounds.

For the most part, the best way to value a small business, is to use the multiplier method, which is where you take the profits of the business, and multiply these profits by a number, or the multiplier.

Now, on the face that sounds simple, when actually it’s not as straightforward as it first appears, and let me explain why.

The first question to ask, is what profits should be used in the valuation calculation?

You may say, “surely profit is profit”, but profits are not always equal, when it comes to small business valuations, as believe it or not, there are many different profit figures.

These various profits figures include, gross profit, profit before tax, profit after tax, EBIT, which is profit before interest and tax, EBITDA, which is profit before interest, tax, depreciation and amortisation, and then there’s SDE, which is seller’s discretionary earnings, which is EBITDA, but with the sellers earnings and benefits added back, and adjusted for non-recurring income and costs.

But actually, non of these are the right profits to use to value a small business, and it’s important to use the right profit figure, to avoid over or under valuing a business.

The other complication with choosing the “right” profit figure for business valuation purposes, is that profits of a company are never the same from one year to the next.

Profits fluctuate, as you’d expect.

So, which profit do you use, and as profits fluctuate from one year to the next, how do you calculate a profit figure to use?

The best profit to use for small business valuation, is to start with EBIT, which is earnings (or profit) before interest and tax, and then adjust this figure with various add backs and deductions, which is similar to, but not exactly the same as SDE, or seller discretionary earnings.

Don’t use EBITDA, as many people suggest, because if you add back depreciation and amortisation, which is what the “D” and “A” stand for, you’ll over-value the business, and you’ll end up over-paying for the business.

To arrive at EBIT, you need financial statements for the business for at least three year’s trading.

Then turn to the profit and loss page of these financial statements, and look for the line described as “profit before tax”, which should be fairly easy to find.

On the same profit and loss page you should also see disclosed, interest payable and interest income. Deduct from the “profit before tax” any interest income, and add back any interest paid, and this will give you your EBIT number.

Do the same exercise for all three years of trading.

Then ask the seller for details of amounts they paid to themselves from the business, including any payments to members of the family, if these family members won’t be carrying on working in the business, post sale.

You need details of their salaries (or wages), benefits, company car costs, pensions and so on.

These are all those costs that will disappear, once the business is your company.

Add these amounts back to your EBIT number, for each of the three years.

Then review the profit and loss for each of the three years, and look for any income or costs that are likely to be non-recurring.

Non-recurring costs would include one-off legal costs, bad debts, excessive repairs or refurbishment costs, losses on sale of equipment, and so on. These costs need to be added back to the profit for each of the relevant three years of trading.

Non-recurring income might include profits on sale of equipment or any other income that is a one-off. This income needs to be deducted from the profits for each of the relevant three years of trading.

You now need to estimate the cost associated with replacing what the owner does in the business, as this work will still need to be done, after they’ve left, and when you own the business.

If there is more than one owner, the same applies for all owners, as it’s important to know what they each do in the business, and what this will cost to replace them once you’ve bought the company.

Calculate a salary for the role of the owner or owners, together with any associated employment costs, and deduct this amount from the profit figure for each of the three years.

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