How a Business Is Valued for Sale: SDE, EBITDA, Multiples, and Terms

Fair Market Value, Investment Value, and the Price a Buyer Pays

Three different numbers all get called “what the business is worth,” and they are different by design.

Fair market value is the tax system’s standard. Treasury regulations define it as the price at which property would change hands between a willing buyer and a willing seller, neither under any compulsion to act and both reasonably informed, and Revenue Ruling 59-60 has guided how appraisers apply that standard to closely held companies since 1959. The buyer in that definition is hypothetical: no particular company, no particular synergies. Fair market value governs gifts, estates, charitable gifts of private stock, and ESOP purchases. In an ESOP sale the price must be supported by an independent appraiser and the plan cannot pay more than fair market value, which is why an ESOP’s price is capped in a way an outside buyer’s is not (our ESOP and Section 1042 article walks through that tradeoff). Applied to a minority or non-marketable interest, fair market value can also carry discounts, so a gift appraisal can legitimately come in well below a later deal price.

Investment value is what one particular buyer could afford to pay. A competitor that can fold your back office into its own, cross-sell your customers, or buy your supplies at its larger volume expects more cash flow from your business than you produce yourself. A buyer using borrowed money, or one whose deal structure gives it a stepped-up tax basis in your assets, sees a different return on the same price. Each serious buyer has its own number.

The price is what a negotiated deal actually pays, in some mix of cash and promises. The highest investment value among the real bidders sets the ceiling; how much of that ceiling the seller captures depends on competition, timing, and how well the business holds up under diligence. A broker’s opinion of value is an estimate of this third number, prepared to set an asking price, which makes it a useful starting point and a poor substitute for the analysis underneath it.

One more term causes trouble in buy-sell agreements and shareholder disputes: fair value. It is a legal standard set by state law for owners who dissent from a merger or claim they were squeezed out, and in many states it excludes the minority and marketability discounts that fair market value allows. An agreement that says “fair value” without defining it is asking a court to choose.

The Earnings Base: SDE or Adjusted EBITDA

Every earnings-based valuation starts by restating the profit the tax return shows into the profit a buyer would expect to own. Two measures dominate, and confusing them is the most expensive mistake in small-business valuation.

A worked example carries through this article. A founder owns and runs a commercial HVAC and plumbing service company outside Houston, organized as an S corporation. Last year’s return shows $690,000 of pretax income. The founder draws a $160,000 salary, which with payroll taxes and benefits costs the company $190,000. The company also paid $40,000 of interest, took $110,000 of depreciation, ran $46,000 of personal expenses through the business, and paid a one-time $70,000 legal settlement. It rents its building from the founder’s real estate LLC for $90,000 a year, though comparable space would rent for $126,000. Hiring a general manager to replace the founder would cost about $210,000 a year, all in.

Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization, normalized) asks what the business earns with a hired manager in the owner’s seat. Starting from the $690,000:

• Add back interest ($40,000) and depreciation ($110,000), which reflect how the business was financed and how its equipment is written off, not what it earns.
• Add back the $46,000 of personal expenses and the $70,000 settlement, which a new owner would not repeat.
• Subtract $36,000, because the building’s rent is that far below market and a buyer’s lease would not be.
• Replace the founder’s $190,000 of total pay with the $210,000 a general manager would cost, a $20,000 subtraction.

That produces $900,000 of adjusted EBITDA. Financial buyers and strategic buyers, who will put their own management in place, price the business on this number.

Seller’s discretionary earnings asks what the business produces for one owner who works in it. It starts from the same normalized figure but adds back the entire cost of one owner-manager instead of charging a market salary: $900,000 plus $210,000, or $1,110,000 of SDE. Smaller businesses, usually bought by an individual who will run them, tend to be priced on SDE, and the multiples quoted for SDE are lower than EBITDA multiples precisely because SDE has not yet paid anyone to run the company. The dividing line is less about size than about who will sit in the operating seat: a modest company with a capable general manager can be priced on EBITDA, and a larger one still run day to day by its founder may be priced on SDE.

The two measures describe the same business and are $210,000 apart. Apply an EBITDA-style multiple of 4.0 to the SDE figure and the result is $4,440,000, $840,000 more than the same multiple applied to EBITDA. An owner who hears a multiple at a conference or from a friend’s sale, and applies it to the wrong earnings measure, can anchor on a number no buyer will pay.

The replacement salary is itself a negotiated number, and the incentive runs toward the buyer. As Chen points out, every dollar a buyer adds to the assumed manager’s pay comes off the price at the multiple: at 4.0, assuming $250,000 instead of $210,000 takes $160,000 off the value. Compensation surveys and what comparable companies actually pay for the role are the seller’s best evidence.

One point for S corporation owners: the salary set for payroll purposes does not drive value. A buyer resets the owner’s pay to what a replacement would cost, so a salary set low (or high) for tax reasons is simply reversed in the normalization. The salary question has its own standards, covered in our article on reasonable compensation for S corporation owners.

Normalizing the Numbers: Which Add-Backs Survive

Add-backs are the adjustments that turn reported profit into normalized profit, and every dollar of them is multiplied in the price. That makes them the most negotiated lines in the valuation.

What buyers accept. Owner compensation reset to market, true one-time costs (a lawsuit, a relocation, a failed product launch) with documentation, and related-party items restated to market generally survive. So do accounting adjustments, such as restating cash-basis books to accrual, that change when income is counted rather than how much there is.

Normalization runs both ways. One-time income comes out too: a gain on selling equipment, an insurance recovery, a contract that will not repeat, or a government credit or forgiven loan from an unusual year.

What buyers discount. Projected savings that have not happened yet, revenue from a contract signed last month annualized as if it had run all year, and recurring costs labeled “one-time” every year rarely survive intact. Buyers also weight the trend: the most recent twelve months count most, an unusually strong year gets averaged with its neighbors, and deferred maintenance shows up as capital spending the buyer will have to make. Nor do buyers add back costs a seller simply wishes it had not incurred: a marketing campaign that failed or a manager who is overpaid is still a cost of running the business, and the time to fix the second is before the sale. Income that never reached the books or the tax return earns nothing in a sale.

The add-back that cuts both ways. Personal expenses run through the business are a common add-back and an uncomfortable one, because each one tells a buyer that the business has been deducting costs that were really personal. Buyers know it, which is one reason they discount these lines. Lenders financing an individual buyer also underwrite largely from tax returns, so earnings that exist only as add-backs support less borrowing, which limits what those buyers can pay. A long list of add-backs costs twice: rejected ones come out at the multiple, and the list itself invites closer diligence and tougher contract protections. That is why the cleaner path is to stop running them through the business years before a sale, as our business exit planning timeline recommends.

The rent that moves value between pockets. The $36,000 rent adjustment lowers the business’s value by $144,000 at a multiple of 4.0, but it is not lost. If the founder keeps the building and leases it to the buyer at market, the property’s income rises by the same $36,000, which at an illustrative 8% capitalization rate is worth about $450,000 to the building. The rent the family has been charging itself was always a choice about which pocket held the value; the sale is when both pockets get priced. Whether to sell the building with the business or keep it and sign a lease is a separate decision with its own tax and income consequences, and it is worth making on purpose rather than by default.

What Sets the Multiple: Risk, Growth, and Cash Conversion

A multiple looks like a market convention, and in practice the multiple a buyer quotes often comes from what comparable companies sold for. Underneath, it is a compressed version of the discounted cash flow math every buyer runs, and that math explains why comparable deals cleared where they did and what moves a multiple up or down.

The formula. A buyer who expects a business’s free cash flow to grow steadily values it at next year’s free cash flow divided by the difference between the return the buyer requires and the expected growth rate. Free cash flow is not EBITDA: it is what remains after the capital spending needed to keep the business running, the extra working capital that growth ties up, and the buyer’s own taxes. So the EBITDA multiple works out to the share of EBITDA that becomes free cash flow, divided by the required return minus growth. When growth will not be steady (a new location ramping up, a large contract just signed), appraisers project the next several years explicitly and apply the same capitalization step only at the end.

The example’s multiple. For simplicity, treat the $900,000 as next year’s normalized EBITDA, and suppose about 60% of it becomes free cash flow after equipment replacement, working capital, and taxes, or $540,000. A buyer requiring a 20% return and expecting 5% growth divides by 15%: the multiple is 0.60 divided by 0.15, or 4.0, and the value is $3,600,000. Every number in that sentence is illustrative; actual required returns, growth expectations, and cash conversion come from the buyer, the industry, and the business itself. Quoted multiples are usually applied to trailing earnings, and on that basis the same assumptions imply a slightly higher multiple, 4.2, because next year’s earnings are expected to run 5% above last year’s.

The three channels. Every value driver an owner can work on moves one of three inputs. The earnings base is the normalized EBITDA itself. Cash conversion is how much of it the buyer keeps. The denominator is the buyer’s required return minus expected growth. Seen that way, a few comparisons become concrete:

• Risk. Suppose diligence shows that most of the customer relationships run through the founder, or that two customers produce a large share of revenue. If the buyer adds three points to its required return, to 23%, the multiple falls to about 3.33 and the value to $3,000,000. That $600,000 is the price of owner dependence or concentration in this example.
• Capital intensity. Take a second company with the same $900,000 of EBITDA and the same risk, but a fleet and equipment base that consumes more cash, so only 50% of EBITDA becomes free cash flow. Its multiple is also about 3.33, and its value also $3,000,000. The same EBITDA is not the same business.
• Growth. If the buyer believes growth will run at 6% rather than 5%, the denominator shrinks to 14%, the multiple rises to about 4.29, and the value to about $3.86 million.

Near this example’s numbers, each percentage point added to or removed from the denominator moves the value by roughly 6% to 7%. That sensitivity is why the operational work in the years before a sale (a management layer that runs the business without the founder, recurring service contracts, a broader customer base, documented systems) is worth so much more than its cost: each one works on the denominator, and the denominator is multiplied across the entire earnings base.

Size and the buyer pool. Smaller companies usually carry higher required returns, because a single lost customer or departed employee matters more, and because the buyers who can purchase them are different. An owner-operator buying a business with a bank loan (often one guaranteed by the Small Business Administration), a private equity fund building a platform, and a strategic acquirer each underwrite risk differently, and a business that grows past the size one group buys can find a different, deeper buyer pool on the other side.

Cross-Checks: The Market and Asset Approaches

The earnings-based method above, which appraisers call the income approach, is the core of most operating-company valuations, but appraisers and buyers test it against two others.

The market approach looks at what similar companies sold for, using databases of private transactions and, with large adjustments for size and liquidity, the trading values of public companies. It is a useful sanity check on a capitalization rate and a dangerous substitute for one. Rule-of-thumb multiples of revenue are the clearest example: two companies with the same revenue and different margins are worth very different amounts, and a revenue multiple means something only where margins are predictable, as in some recurring-revenue businesses and many professional practices, where deals are often stated as a multiple of revenue with part of the price tied to how many clients stay.

The asset approach adds up what the company’s assets (equipment, vehicles, inventory, receivables, real estate) are worth at market, less its liabilities. For a healthy service business it sits well below the earnings value, and most of the difference is goodwill. For an asset-heavy or underperforming business, it can be the floor, and occasionally the earnings value falls below it: the business is then worth more as a collection of assets than as a going concern, and the real decision may be an asset sale or an orderly wind-down rather than a sale of the business. In any asset sale, how the price is allocated across asset classes decides how much of the gain is ordinary income and how much is capital gain, which our article on asset sales versus stock sales explains.

From Headline Price to Cash at Close

This section and the next follow Chen’s analysis closely; he writes about advisory-firm sales, but the mechanics apply to most private companies.

Most offers to buy a private company are stated on a cash-free, debt-free basis: the price is the enterprise value of the business, assuming the buyer receives it without debt and the seller keeps any excess cash. Suppose the founder accepts an offer of $3,600,000, structured with $360,000 as an earnout paid only if revenue targets are met over the next two years, $360,000 as a seller note paid over four years, and the rest in cash at closing.

Debt. The company’s $420,000 of equipment loans and line of credit is paid off from the proceeds at closing. That is not lost value; it was owed either way. It is the difference between enterprise value and equity value, which here is $3,180,000. Buyers also treat some obligations that are not loans as debt: customer deposits and prepaid service agreements the buyer will have to honor without being paid again, accrued bonuses and unpaid taxes, and deferred compensation or phantom equity promised to key employees can all come off the price dollar for dollar. This example assumes none, but for a service company that sells maintenance plans in advance, the prepaid portion can be meaningful.

Working capital. The price assumes the business arrives with a normal level of working capital, its receivables and inventory net of payables, defined by a target (the peg) negotiated in the purchase agreement. Here the peg is $500,000 and the company delivers $455,000 at closing, so the price falls by $45,000, dollar for dollar. How the peg is defined (a trailing average, a seasonal adjustment, which accounts count) is worth real money and is negotiated hard. Collecting receivables aggressively in the weeks before closing does not help: it simply lowers the working capital delivered, and the final figure is usually trued up a few months after closing, once receivables and payables have settled. A leaner working capital cycle built and sustained over several quarters before a sale is different. Because the peg is usually set from a trailing average, the lower level becomes the target, and the cash freed along the way stays with the seller.

Transaction costs. The broker or banker’s fee, legal fees, and accounting work come to $240,000 in this example and are paid from the proceeds.

The escrow. $270,000 of the price is held in escrow for 18 months to cover claims that the seller’s representations about the business were wrong. If no claims arrive, it is released; in larger deals, representations and warranties insurance can reduce or replace the escrow.

What arrives at closing. Of the $3,600,000 headline, $2,880,000 is the cash portion, and after the debt payoff, the working capital shortfall, transaction costs, and the escrow, $1,905,000 is wired at closing: a little more than half the headline, before any tax.

The rest is a promise. The $360,000 seller note makes the founder a lender to the buyer, secured by a business the founder no longer controls and usually subordinated to the buyer’s bank. The $360,000 earnout is worth only what the targets are likely to produce; if hitting them is a coin flip, its expected value is $180,000, before any discount for waiting two years. Some private equity deals add rollover equity, part of the price paid in the buyer’s own stock for a second sale years later; it can often be structured to defer tax, though structure matters if Qualified Small Business Stock is involved, as our article on QSBS under OBBBA explains.

Then the tax. Whether the deal is an asset sale or a stock sale, how the price is allocated, and when each payment arrives decide the tax on every one of these dollars; the note and the earnout generally follow the timing rules explained in our article on installment sales and earnouts. Texas has no personal income tax, so for a Texas owner the federal structure and timing carry most of the weight. One state item is worth raising with the company’s CPA before the structure is set: the franchise tax. In an asset sale, or a stock sale treated as an asset sale for tax purposes, the gain generally becomes part of the selling entity’s revenue for that year’s franchise tax calculation.

Diligence: Where Values Get Re-Traded

A letter of intent prices the business on the seller’s numbers. Diligence then tests them, and a price can change after the seller has stopped talking to other buyers.

The quality of earnings review. Private equity buyers, and many other buyers of a business this size, hire an accounting firm to produce a quality of earnings report, which rebuilds EBITDA from the books, tests each add-back, examines revenue recognition and customer concentration, and proposes the working capital peg. Every adjustment it makes is repriced at the multiple. The most contested lines are costs a seller calls one-time and a buyer calls the price of staying in business: a new dispatch system, a push to hire technicians, a year of overtime covering an open position. If the buyer’s accountants accept only $26,000 of the founder’s $46,000 of personal-expense add-backs, adjusted EBITDA falls to $880,000 and the price, at 4.0, to $3,520,000: each dollar of rejected add-back costs four dollars of price.

Why the timing matters. Most letters of intent include an exclusivity period during which the seller cannot negotiate with anyone else. By the time diligence finds a problem, the competitive tension that produced the price is gone. Some sellers commission their own quality of earnings review before going to market, which costs money but finds problems while there is still time to fix or explain them, and makes the buyer’s review harder to use as a lever.

Who Should Value Your Business, and When

Valuation work comes in grades, and the right one depends on what the number will be used for.

A broker’s opinion of value is an estimate of likely price, prepared to win a listing or set an asking price. It is often free or inexpensive, and it is only as good as the normalization and the comparables underneath it.

A calculation engagement, under the professional standards accountants follow, applies valuation procedures agreed on with the client and produces a calculated value. It is a practical way to establish a baseline years before a sale.

A valuation engagement produces a conclusion of value from a full analysis and is the grade generally expected for tax filings, ESOP transactions, litigation, and gift and estate work. Credentials signal training in these methods: the ABV (Accredited in Business Valuation) awarded by the AICPA, the ASA (Accredited Senior Appraiser) from the American Society of Appraisers, and the CVA (Certified Valuation Analyst) from the National Association of Certified Valuators and Analysts.

Purpose also decides the standard. An appraisal prepared for a gift answers the fair market value question; sale planning is better served by someone who knows how buyers in the industry actually price deals.

Timing follows purpose. A baseline belongs two to five years before a planned sale, when there is still time to work on what the valuation reveals. A formal appraisal is the usual support for gifts or trust sales of business interests, and its value as a planning tool depends on being completed before a buyer names a number, as our article on estate planning before a business sale explains. And a buy-sell agreement’s price mechanism deserves a fresh look whenever the business’s value has moved, which our buy-sell agreements after Connelly piece covers.

How We Think About It

We lean toward getting a baseline valuation two to five years before a planned sale, from someone who works with the methods described here. Early on, that need not be a formal appraisal: a calculated value or a well-supported estimate is enough to measure the gap between what the business is likely worth and what the owner’s plan needs. A formal conclusion of value earns its cost when something depends on it, such as a gift or trust sale before a letter of intent, an ESOP, or a buy-sell price. A broker’s opinion of value or a rule-of-thumb multiple is a starting point for that conversation, not its answer.

We lean toward judging an offer by what reaches the seller after terms and taxes, not by its headline. Cash at closing, the escrow, the note, the earnout, and any rolled equity carry different risks and different tax timing, so two offers with the same headline can be worth very different amounts, and a lower headline with more cash and cleaner terms is sometimes the better deal. As with the asset-versus-stock spread and an ESOP’s after-tax comparison, the difference is a number worth computing rather than a judgment made from the headline.

We lean toward working backward from the number the plan needs rather than forward from a multiple. What matters is the after-tax, after-terms amount that lets an owner live the next chapter they have described, and how much of the value-building work stands between today’s value and that number. That gap, not the multiple someone mentioned, sets the timeline.

Common Questions

How is a small business valued for sale?

Most operating businesses are valued by applying a multiple to a normalized measure of earnings: seller’s discretionary earnings for smaller owner-operated companies, adjusted EBITDA for companies a buyer will run with hired management. Normalizing means adding back interest, depreciation, owner perks, and one-time costs, removing one-time income, and restating owner pay and related-party rent to market. The multiple reflects the buyer’s view of risk, growth, and how much of the earnings becomes cash. Appraisers cross-check the result against comparable sales and the value of the company’s assets.

What is the difference between SDE and EBITDA?

Seller’s discretionary earnings adds back the entire cost of one owner-manager, so it measures what the business produces for an owner who works in it. Adjusted EBITDA charges a market salary for a hired manager, so it measures what the business earns for an owner who does not. The same business can show SDE hundreds of thousands of dollars higher than its EBITDA, and multiples quoted for one cannot be applied to the other.

What multiple will my business sell for?

There is no standard multiple. A multiple is shorthand for the share of earnings that becomes free cash flow, divided by the buyer’s required return minus expected growth. Customer concentration, dependence on the owner, capital intensity, size, and the type of buyer all move it, and in this article’s example a single percentage point of required return moves the value by roughly 6% to 7%. Multiples from other sales are useful cross-checks only when the earnings measure and the businesses are truly comparable.

Why is the cash I receive at closing less than the sale price?

Because the headline price is usually an enterprise value paid partly in promises. Debt and debt-like obligations are paid off from the proceeds, a working capital adjustment moves the price up or down, transaction costs are paid at closing, an escrow holds part of the price against claims, and a seller note or earnout pays later, if at all. In this article’s example, a $3,600,000 offer wires $1,905,000 at closing, before any tax.