Why Valuation Matters
Whether you’re an owner thinking about selling one day or a buyer looking for the right opportunity, understanding how to value a small business is the starting point for any serious conversation.
If you’re a seller, valuation helps you look at your business like an outsider, focusing on what makes it valuable instead of your personal feelings. If you’re a buyer, it ensures you’re paying a fair price not just for today’s performance, but also for how the business might do in the future.
The good news? Business valuation doesn’t have to feel overwhelming or mysterious. There’s a straightforward formula and a few main factors that determine what a business is worth.
In this guide, we will explain the basics in simple language, so you understand how valuation works and make smarter choices, whether you want to sell, buy, or just plan for the future.
The Valuation Formula (Core Framework)
There are many ways to value a small business, but the most commonly used is:
Business Value = Seller’s Discretionary Earnings (SDE) × Industry Multiple
This helps both sellers and buyers focus on how much money the business really makes and how the market decides its worth.
What is Seller’s Discretionary Earnings (SDE)?
SDE (Seller’s Discretionary Earnings) shows how much cash a business really makes for one owner who runs it. You start with the net profit from the financial statements, then make adjustments to get a more accurate picture of the business’s actual earnings.
A key part of calculating SDE is “add backs.” These are expenses that get added back to the profit number because they are unlikely to be expenditures incurred by the next owner. Examples include:
- Owner’s personal expenses (like personal meals, health insurance, car, or travel for the owner)
- One-time costs (such as legal fees for a special case or setting up a new office)
- Non-cash expenses (like depreciation)
What Are Industry Multiples?
Once SDE is calculated, it is multiplied by an industry multiple, a number that represents how businesses in that sector are typically valued.
Industry multiples vary depending on three key factors: growth prospects, risk, and profitability. For example:
- AI and software companies are often trading at higher multiples compared to most industries because of the space being viewed as the future, where new products, market expansion, and growth opportunities can be created.
- A plumbing company with a history of consistent and strong revenue might trade at a higher multiple than a retail toy store with similar financial performance, because people assume that during an economic downturn, people are more likely to drop spending on toys, but plumbing issues need to get fixed regardless.
- A business with recurring revenue, for example, a janitorial service with municipal contracts, can demand a higher multiple than ones that sell one-off projects because it signifies stability and predictability, reducing risk for investors and buyers.
Other Valuation Methods
While SDE × Industry Multiple is the most common method for small businesses, there are other approaches:
1. Discounted cash flow (DCF):
Another income-based valuation approach, DCF, is a more complex method that projects earnings over multiple future years and discounts them to a present value. It is particularly useful for growing companies with an unpredictable future but relies heavily on accurate forecasting.
2. Market approach:
This method determines a business’s value by comparing it to similar businesses that have recently been sold. This approach operates on the principle that a business is only worth what a buyer is willing to pay for a comparable company.
3. Asset-Based Valuation:
This method determines a company’s value by calculating the total market value of its assets and subtracting its liabilities. This is often used by asset-heavy businesses such as manufacturing or real estate companies.
The three most common asset-based valuations are:
(a) Adjusted net asset method: In this method, all tangible assets (equipment, real estate) and intangible assets (patents, brands) are valued at fair market value, and then reduced by the company’s total liabilities.
(b) Liquidation value: This conservative measure estimates the value of a business as if all its assets had to be sold off and the operation ceased. This is often used as the “floor” value of the business.
(c) Book value: Relies on the book values of assets and liabilities from the balance sheet, which is the simplest yet often least accurate method of asset-based valuation because it may not reflect current market values.
Key Factors That Affect the Multiple
When it comes to business valuation, the multiple applied to earnings isn’t just about the numbers. It reflects how attractive, resilient, and scalable the business looks to a potential buyer. Three factors drive this most:
1. Growth Opportunities
Multiples rise when buyers see a clear path for expansion. For example, a commercial cleaning company adding specialized services like medical facility sanitization can grow revenue faster than one limited to office contracts.
Similarly, a software firm in a rapidly expanding niche will command a higher multiple than one in a stagnant sector. Buyers pay for what a business can become, not just what it is today.
2. Risk
High risk lowers multiples. A marketing agency that relies on two clients for 70% of its revenue will be valued less favorably than a competitor with dozens of steady accounts.
Likewise, a manufacturing firm where the founder personally manages sales and operations is seen as fragile compared to one with a strong management team. Diversification, delegation, and longevity reduce perceived risk.
3. Profitability
Profitability reflects both discipline and resilience. A landscaping company earning 25% net margins on recurring contracts is more attractive than one with 10% margins tied to seasonal, one-off jobs.
In the same way, a professional services firm with steady cash flow year over year will be valued more highly than a peer with volatile results. Strong, sustainable margins give buyers confidence the business can weather downturns.
Now that you understand what shapes the multiple, let’s see how the math plays out in practice.
A Simple Example Calculation
Let’s make the formula real. Imagine a training business with $3M in annual revenue. After normalizing expenses (owner salary, one-time costs, personal perks), the business has a Seller’s Discretionary Earnings (SDE) of $600,000.
If the average industry multiple is 3x, here’s what the math looks like:
Business Value = SDE × Multiple
$600,000 × 3 = $1.8M
How Changes Affect Valuation
Even small shifts in financials or risk can change the outcome dramatically.
| Scenario | SDE | Multiple | Valuation | Why It Changed |
| Baseline | $600,000 | 3x | $1.8M | Stable, healthy margins |
| Higher Margins | $750,000 | 3x | $2.25M | Improved efficiency raises SDE |
| Riskier Client Base | $600,000 | 2.5x | $1.5M | Over-reliance on 1–2 clients lowers multiple |
| Stronger Team & Systems | $600,000 | 3.5x | $2.1M | Reduced founder dependency boosts multiple |
Common Mistakes in Valuation
1. Overestimating Due to Emotional Attachment
Owners often see their business as priceless because of the years of effort poured into it. But buyers don’t pay for sentiment. They pay for earnings, systems, and stability.
If you’re thinking of selling your business, make sure to ask these questions before choosing a buyer to avoid emotional decision-making and find someone who genuinely fits your values.
2. Ignoring One-Time or Personal Expenses in SDE
Seller’s Discretionary Earnings (SDE) only works if you adjust for add backs properly. That means removing personal perks (like a family car on the books) or one-off expenses (like a one-time legal fee). If you don’t, your numbers may be misleading.
3. Overemphasis on “Future Projections” vs. Historical Performance
Sellers often argue, “The market potential is huge, so we should be valued higher.” But buyers focus on what’s proven, not just possible. A business isn’t worth more today because of what might happen tomorrow. Future growth can be rewarded in special deal terms, not by increasing the current value.
4. Overreliance on a Single Strong Year
One great year doesn’t equal a trend. Serious buyers look at the last two to three years of performance to judge consistency. If last year was a fluke, it won’t justify a higher valuation until it’s repeated.
5. Using the Wrong Multiple
Not all industries are valued the same way. A boutique marketing agency won’t have the same multiple as a plumbing company. Using a generic “rule of thumb” without considering your industry can lead to dangerous mispricing.
Beyond the Numbers: Why Deal Terms Matter
Valuation is the headline number, but it’s not the whole story. The real value of a deal depends on how it’s structured.
Two buyers might both offer $5 million for your business, but the way the deal is structured can make one offer much better than the other. Here’s why:
1. Seller Financing
Instead of paying 100% upfront, the buyer pays a portion over time.
Why this can be good: Creates ongoing income for the seller, gives the buyer room to ensure the business can continue during the transition, and often results in a higher total price.
2. Earnouts
Part of the sale price is tied to future performance. For example, if the business hits certain revenue or profit targets in the next two years, the seller gets an additional payout.
Why this can be good: Bridges the gap between what the seller believes the business is worth based on market opportunity and what the buyer is comfortable paying today based on historical record.
3. Working Capital
Buyers expect the business to come with enough working capital, such as cash, accounts receivable, and inventory, to keep operations running smoothly after the sale.
Why this can be good: Ensures the business doesn’t stall immediately after closing, avoids disputes over cash needs, and makes the transition seamless. Sellers who leave adequate working capital demonstrate goodwill and protect the headline valuation they negotiated.
Valuation Is Clarity, Not the Final Word
Knowing your business’s value isn’t just for selling right now; it’s about understanding where you stand.
A clear valuation shows you how your business looks to buyers, helps you see ways to build more value, and lets you plan your next steps, whether that’s growing, passing it on, or selling later. Think of valuation as a helpful tool for planning, not a fixed price tag.
Our Approach at AA24 Holdings
At AA24 Holdings, we’re not just chasing quick deals. We look for strong, well-run businesses where people, systems, and legacy matter as much as profit margins.
When we buy, we aim to preserve what makes the business valuable in the first place:
- The team behind it
- The reputation in the community or industry
- The processes that keep things running smoothly
For us, valuation is the start of a conversation, not the end of one.
If you’re curious about what your business might be worth, or just want to explore what a thoughtful exit could look like, let’s talk.
Just a real conversation about your future and your legacy.
📩 Contact us: contact@aa24holdings.com
