How small businesses are valued: profit, multiples and what buyers pay for

A business is worth what an informed buyer will pay for it, and most buyers are paying for the profit they expect it to make. Valuation methods are ways of estimating that number and explaining it. This guide covers the methods used for most small businesses in Australia. For a quick estimate of your own, try What's my business worth?.

Start with the right profit figure

Before any multiple can be applied, buyer and seller need to agree which profit they are talking about. Listings use three common measures, and they are not interchangeable.

• Net profit. What is left after all expenses. Whether this already includes a wage for the owner varies, so always ask.
• EBITDA. Earnings before interest, tax, depreciation and amortisation. It is often used for larger businesses with a management team, where the owner is not working in the business day to day.
• Owner's benefit. Sometimes called seller's discretionary earnings: the total financial benefit to one full-time working owner, including their wage and personal expenses run through the business. It is common for smaller, owner-operated businesses and is usually the highest of the three figures.

Sellers often "normalise" profit by adding back personal and one-off expenses. Buyers should accept only add-backs the seller can prove. The most important adjustment is the owner's own work: if the owner works sixty hours a week without a wage, a buyer who wants to employ a manager has to pay for those hours, and the real profit is lower.

BizExchange listings say which profit basis they use, so you can compare like with like.

The earnings multiple method

The most common method for small businesses multiplies a profit figure by a number that reflects risk:

Price = profit × multiple

A higher multiple means a buyer is paying more for each dollar of profit, which they will only do if they believe the profit is reliable and will last. Multiples vary widely between industries, between businesses of different sizes and between individual businesses in the same industry, so a multiple from one sale is not a rule for another.

The multiple shown on BizExchange cards is simply the asking price divided by the published profit. It helps you compare listings quickly, but it is a seller's asking position, not an agreed value.

The asset-based method

For businesses with modest profits or a lot of valuable equipment, the starting point is what the assets are worth: plant, equipment, vehicles and fit-out at their current market value, not what they cost new. If the business earns little more than a fair wage for the owner, the price may not be much more than the value of the assets.

Stock is normally treated separately. Many listings say "plus stock at valuation" (SAV), meaning the buyer pays for saleable stock on top of the price, at a value worked out at or around settlement. See stock at valuation.

Comparing with similar businesses

Looking at similar businesses for sale gives a sense of the market. Keep two limits in mind: asking prices are not sale prices, and no two businesses have the same lease, location, staff and customers. Use comparisons to test a valuation, not to replace one.

What pushes the price up or down

Buyers pay more for businesses that are lower risk and easier to take over. Things that tend to support a higher price:

• several years of steady or growing profit, backed by clean records
• a long lease with options at a sustainable rent
• a business that runs without the owner, with trained staff and written processes
• a wide spread of customers, or customers on contracts
• recurring or repeat revenue
• equipment in good condition.

Things that tend to reduce it:

• a short lease or a landlord who has not agreed to an assignment
• profit that depends on the owner's personal skills, licences or relationships
• one or two customers making up most of the revenue
• falling sales, or figures that cannot be verified
• equipment that will soon need replacing
• changes coming in the market, such as new competition or regulation.

Asking price and sale price

The asking price is where negotiation starts. Buyers make offers based on what they find in due diligence, and the final price reflects the risks they uncover. A seller with good records and a realistic asking price tends to spend less time negotiating.

Getting a valuation

An accountant can prepare a valuation from your financial statements and explain the profit adjustments. A business broker can give a market appraisal based on what similar businesses are listed and selling for. For complex or disputed situations, consider a qualified business valuer. Whoever you use, ask them to show which profit figure and which method they used, so you can explain the price to a buyer.