Business Valuation
A business valuation is a structured estimate of what a company is worth, used for selling, raising money, settling disputes, or planning an exit. Professionals weigh three approaches: what the assets are worth, what the earnings are worth, and what comparable businesses have sold for. For most small businesses the earnings approach, applied as a multiple, drives the number.
Why a real valuation differs from a guess
Owners routinely carry a number in their head for what the business is worth, usually anchored to revenue or to what a neighbor’s company sold for. A formal valuation replaces that anchor with a defensible method. The framework most appraisers work from traces to a 1959 IRS document, Revenue Ruling 59-60, which set out how to determine the fair market value of a closely held business and listed the specific factors an appraiser must weigh, from the company’s history and earning capacity to the prices of comparable businesses [1]. Its definition of fair market value, the price a willing buyer and willing seller would agree on, neither under compulsion, remains the standard the whole field uses [2].
The three approaches
Revenue Ruling 59-60 instructs a valuator to consider three approaches in every assignment, and a credible valuation reconciles them rather than relying on one [1] [9].
| Approach | What it measures | Best for |
|---|---|---|
| Asset (cost) | Net value of assets minus liabilities, including intangibles. | Asset-heavy or holding companies, as a floor value. |
| Income | The earnings the business produces, capitalized or discounted to today. | Profitable operating companies, usually the driver. |
| Market | What comparable businesses actually sold for, expressed as a multiple. | Companies with good comparable-sale data. |
In practice the income and market approaches converge through a multiple. The appraiser establishes a normalized earnings figure, then applies a multiple drawn from comparable transactions. The asset approach typically sets a floor, the value below which an owner would rather liquidate than sell. Standard references describe these same three approaches as the universal grammar of valuation, applied across professional methods [5] [6].
Normalizing the earnings first
Before any multiple is applied, the earnings have to be normalized, and this step quietly decides much of the answer. Normalization strips out the distortions that make a private company’s reported profit unreliable as a measure of its true earning power. An appraiser adds back the owner’s above-market salary, personal expenses run through the business, and genuine one-time costs, while removing one-time gains and adjusting any related-party transactions to market terms [3]. A business reporting $200,000 in net income might normalize to $400,000 once the owner’s discretionary spending is added back, and since the figure is then multiplied, every dollar of accurate normalization moves the valuation by the full multiple. This is also why buyers scrutinize add-backs so hard: an aggressive or undocumented add-back is the fastest way to lose credibility and trigger a lower offer.
SDE versus EBITDA: the number that gets multiplied
The earnings figure matters as much as the multiple, and which one applies depends on size. For small, owner-operated businesses the standard metric is seller’s discretionary earnings, or SDE, which starts from net income and adds back the owner’s salary, perks, and one-time expenses to show the full financial benefit to a single owner-operator [3]. Larger, professionally managed companies are valued on EBITDA instead, because they already pay market-rate management and the owner add-backs no longer apply. Getting this wrong is a common error: applying an EBITDA multiple to an SDE figure, or the reverse, can misstate the value by a wide margin, because the two earnings bases are not interchangeable [3].
What drives the multiple
Two businesses with identical earnings can be worth very different amounts, and the gap is the multiple. The factors that move it are consistent. Size matters, because larger companies command higher multiples and carry less risk. Growth matters, because a rising trend is worth more than a flat one. Customer concentration matters, because dependence on a few accounts depresses value. Owner dependence matters, because a business that cannot run without the founder is hard to transfer. Recurring revenue matters, because predictable income is worth more than one-off project income. And clean, trustworthy financials matter, because a buyer discounts numbers they cannot verify [1] [3] [5]. An owner who wants a higher valuation works on these well before a sale, since most are slow to change.
Worked example: the same earnings, two very different values ILLUSTRATIVE EXAMPLE
This is a simplified illustration, not a specific company. Two service businesses each show $500,000 in normalized SDE. Business A has one customer worth 60 percent of revenue, an owner who personally holds every key relationship, and books that take an accountant a week to untangle. Business B has no customer above 10 percent of revenue, a management team that runs daily operations, recurring contracts, and clean monthly statements.
Sold on SDE multiples, Business A might attract a multiple near 2.0, valuing it around $1 million, and even that price will draw a buyer demanding a large earnout because the risk is obvious. Business B, with the same earnings, might command a multiple near 3.5 or higher, valuing it above $1.75 million, and sell closer to asking with less of the price held back. The earnings were identical. The difference, more than $750,000, was entirely in the quality and transferability of those earnings. The lesson is that a valuation measures not just how much a business earns, but how safely and transferably it earns it.
What owners get wrong about valuation
The most common mistake is confusing revenue with value. A business is valued on its earnings and their quality, not its top line, which is why two companies with the same sales can be worth multiples apart. The second mistake is trusting a rule-of-thumb multiple as if it were a valuation. Industry rules of thumb are a useful sanity check and a terrible substitute for one, because they ignore the specific factors, concentration, growth, owner dependence, that actually set the price for a particular company [7].
The subtler error is timing. Owners commission a valuation when they are ready to sell, which is exactly too late to change the number. The factors that drive the multiple, reducing customer concentration, building a management layer, cleaning up the financials, take one to three years to move. A valuation obtained early functions as a roadmap for raising the number, which is the real reason it belongs in exit planning rather than at the closing table.
Who performs one, and when an owner needs it
The rigor required depends on the purpose. A formal valuation for a legal matter, an estate filing, or a dispute should come from a credentialed appraiser whose report documents the three approaches and the relevant factors, because it must withstand scrutiny from a court or the IRS, and credentialed analysts are trained and certified specifically to produce reports that do [8] [10]. A valuation to inform a potential sale can be lighter, often a broker’s opinion of value grounded in recent comparable transactions. A valuation for the owner’s own planning can be lighter still, a directional estimate updated annually to track whether the value is moving the right way.
The events that should trigger one are predictable: preparing to sell or buy, raising equity, bringing in or buying out a partner, divorce or estate planning, and benchmarking progress toward an eventual exit. In each case the cost of a professional valuation is small against the size of the decision it informs, and the larger danger is not paying for one but trusting a number that was never tested [2] [4].
One practical habit separates owners who sell well from those who are surprised at the table: treating valuation as a recurring measurement rather than a one-time event. A directional valuation refreshed each year turns the abstract question of what the business is worth into a concrete scoreboard, showing whether the past twelve months added enterprise value or merely added revenue. Owners who watch that number make different operating choices, favoring the recurring contract over the one-off project and the second key client over the convenient single account, because they can see each decision move the multiple. By the time a real sale arrives, the work that raises the price is already done, and the formal valuation confirms a number the owner has been building toward for years rather than discovering for the first time.
Sources
- LegalClarity, What Is Revenue Ruling 59-60 for Business Valuation? (the framework and its eight factors).
- Cornell Legal Information Institute, Fair Market Value (willing-buyer / willing-seller standard).
- Baton Market, Earnings-Based Valuation for Small Businesses (SDE vs EBITDA, multiples).
- U.S. Small Business Administration, Manage Your Finances (financial records context).
- Corporate Finance Institute, Valuation Methods (asset, income, market approaches).
- Investopedia, Business Valuation (methods overview).
- Sofer Advisors, Rule-of-Thumb Business Valuation: Uses and Limitations.
- National Association of Certified Valuators and Analysts, NACVA (professional valuation credentialing body).
- Corporate Valuations Inc., Understanding Revenue Ruling 59-60 (the factors in detail).
- Sofer Advisors, FMV of Closely Held Business Stock: IRS Methods.