What is a small business worth? How buyers set a price

When you buy a house, you can look up what similar homes nearby sold for. Small companies don't work that way: there's no public record of what they sell for, each company is different, and the asking price is whatever the owner, or the owner's broker, hopes for. So how do buyers, sellers and lenders arrive at a number they can all defend?

For established small companies, the answer usually starts with two things: what the company earns for its owner, and how many years of those earnings a buyer will pay for.

Start with owner earnings

Owner earnings are the company's profit plus what the owner pays themselves, before loan payments and taxes. The figure answers the question a buyer cares about: if you owned this and ran it, how much money would it produce each year for you and your lender to share?

You build it from the tax returns, adding back the owner's pay and benefits, interest, depreciation and documented one-time or personal costs. Our post on add-backs goes through which adjustments hold up. Use the most recent full year, or an average of recent years if earnings bounce around, and be skeptical of a single great year.

Then a number of years

Since those sales aren't public, any range is an estimate. The model behind Second & Main's estimates puts most established companies at around 2.5 to 3.5 times a year's owner earnings, with a different range for each industry. A few examples:

• about 1.8 to 2.6 times for restaurants
• about 2.2 to 2.7 times for commercial cleaning companies
• about 2.5 to 4 times for HVAC companies
• about 3.2 to 3.9 times for managed IT services firms

These are our model's ranges, not a record of actual sales, and a real company can land outside them. Think of the number as a payback period. At 3 times, the price equals three years of what the company produces for its owner. That sounds quick, but out of those earnings you also have to pay yourself, repay the loan and absorb whatever goes wrong.

Why the buyer's math puts a ceiling on it

A price only makes sense if the company can pay you a salary and carry the loan with room to spare. For an SBA loan to buy a company, the rules require earnings after your salary of at least 1.25 times the yearly loan payments.

Say a company has owner earnings of $300,000 and you need a $100,000 salary. We'll use our usual assumptions: 10% down, about 4% for closing costs, and an SBA loan at about 10.25% over 10 years, where every dollar borrowed costs about 16 cents a year.

• At 3 times, the price is $900,000. You borrow $810,000 and pay about $130,000 a year. After your salary, $200,000 is left: about 1.5 times the payment. That works.
• At 4 times, the price is $1.2 million. You borrow $1.08 million and pay about $173,000 a year. After your salary, $200,000 is about 1.16 times the payment. A lender would say no.

With these numbers, the most you could pay is about 3.7 times earnings. If you needed a $150,000 salary instead, the ceiling would drop to about 2.8 times. The seller's asking price doesn't change this math, which is why a price far above it usually doesn't hold up once a lender gets involved.

What moves the number up or down

Within an industry's range, these are the things that push a company higher or lower.

• Size. Larger companies often sell for more years of earnings. They tend to depend less on one person, have more customers and attract more buyers.
• Recurring revenue. Service contracts, maintenance agreements and repeat customers who come back every year make future earnings more predictable, and predictable earnings are worth more.
• Owner dependence. If the owner is the salesperson, the estimator and the person every customer calls, part of the earnings walks out the door at closing. That lowers the number.
• Customer concentration. When one or two customers bring in a large share of sales, losing one could sink you. Our post on risks that change the price covers this and other risks.
• The trend. Three years of steady growth is worth more than three years of decline, even if the latest year is the same.
• The team. Experienced employees who stay, and a manager who can run the day to day, raise the value.
• Equipment and facilities. Trucks and machines that need replacing soon are a cost hiding in the price.
• The industry itself. Licensing, competition, how easily customers switch, and how much equipment the work needs all shape the typical range.

What the price includes

Two companies at the same price can be very different deals depending on what comes with them. A price typically covers the equipment, the name, the customer relationships and the goodwill. Whether it also includes the cash in the bank, money customers owe, inventory and any existing debts is up for negotiation. Spell it out in your letter of intent, so you're comparing like with like.

How a lender checks the price

If you finance with an SBA loan, someone independent will test the price. When the price, not counting real estate, is over $350,000, the lender must get a business valuation from an accredited appraiser it hires. If you agree to pay more than the valuation supports, the difference has to come from equity (your money, or a seller loan that isn't paid until the bank is), not from a bigger loan. Together, the bank loan and any regular seller loan can't add up to more than the valuation. On purchases of $3 million or more, the lender also needs a quality of earnings report, an independent review of whether the profits are real and will last.

In practice, the lender's valuation acts as a check against overpaying. If it comes back below the agreed price, you'll need to renegotiate, bring more money or ask the seller to wait for part of it. Our post on seller financing explains how that works.

Asking price and value

A seller's asking price reflects what they hope for, what they've heard other companies sold for, and sometimes what they need for retirement. None of that changes what the company can support. Your job in an offer is to show your math: the owner earnings you used, the number of years, and the risks that moved it. A reasoned offer is easier for an owner to accept, or to counter sensibly, than a bare number.

The estimates you see on Second & Main come from public records, not from owners' books. They're a way to decide which companies are worth a conversation. The real number comes from the tax returns.

What to do this week

• Pick a company you're interested in and write down possible prices: low, middle and high owner earnings, times the low and high ends of its industry's range.
• Run each price through the 1.25 test with the salary you need, and cross out the prices that fail.
• List the factors above that would move this particular company up or down, and what you'd need to see to be sure.