Most small and mid-sized private businesses are bought and sold using a multiple of earnings. The buyer takes a measure of annual profit, usually EBITDA, and multiplies it by a number that reflects risk and growth. Simple in concept. In practice, both the earnings figure and the multiple are open to debate, and that debate is where most valuation negotiations happen.
This guide walks through each step with a worked example. It's written for buyers, sellers and advisers dealing with businesses roughly from $500,000 to $20 million of EBITDA. Numbers are illustrative.
What EBITDA is and why buyers use it
EBITDA stands for earnings before interest, taxes, depreciation and amortisation. It approximates the operating cash profit of the business before financing decisions and accounting choices about long-lived assets.
Buyers like it because:
- it removes the effect of the current owner's financing choices (interest),
- it removes tax effects, which change with ownership structure,
- it's comparable across companies with different capital structures.
It has well-known weaknesses. It ignores capital expenditure, which can be significant in asset-heavy businesses, and changes in working capital. Good buyers always look at cash flow alongside EBITDA.
Step 1: Start with reported EBITDA
Take the income statement and calculate:
EBITDA = net income + interest + taxes + depreciation + amortisation.
Use at least three years of history plus the trailing twelve months (TTM). Valuations are usually based on TTM or the most recent full year, but the trend matters.
Step 2: Normalise to adjusted EBITDA
Owner-operated businesses often have expenses that won't continue under new ownership, and sometimes costs that are missing. Adjusted EBITDA corrects for these. Common adjustments:
| Adjustment | Direction | Example |
|---|---|---|
| Owner compensation above market rate | Add back the excess | Owner pays themselves $400k; market rate for a GM is $180k |
| Owner compensation below market rate | Subtract the shortfall | Owner takes $60k; a replacement would cost $180k |
| Personal expenses through the business | Add back | Family vehicles, personal travel |
| One-off costs | Add back | Lawsuit settlement, a one-time relocation |
| Related-party rent at non-market rates | Adjust to market | Owner's property leased to the business cheaply |
| Family members on payroll who don't work | Add back | Salary paid to a relative with no role |
| Missing costs | Subtract | No CFO; buyer will need to hire one |
Sellers naturally push for many add-backs. Buyers should challenge each one. An add-back is legitimate only if the cost genuinely won't continue and can be supported with evidence. A quality of earnings report is the formal way to test them.
Worked example. A commercial cleaning company reports $1,100,000 of EBITDA for the last twelve months.
- Owner salary is $350,000; a general manager would cost $160,000: add back $190,000.
- Personal vehicle and travel expenses: add back $45,000.
- One-off legal costs from a contract dispute: add back $30,000.
- No controller; the buyer will need one at $90,000: subtract $90,000.
Adjusted EBITDA = $1,100,000 + $190,000 + $45,000 + $30,000 − $90,000 = $1,275,000.
SDE vs EBITDA
For very small businesses, often under about $1 million of earnings, brokers commonly use seller's discretionary earnings (SDE) instead of EBITDA. SDE adds back the full owner's compensation, on the assumption that the buyer will run the business themselves.
SDE = adjusted EBITDA + one owner's full compensation.
Multiples on SDE are lower than on EBITDA, because SDE is a larger number that includes what the owner pays themselves. Make sure you know which measure a multiple refers to. Applying an EBITDA multiple to SDE overstates value considerably.
Step 3: Choose a multiple
The multiple reflects how much buyers will pay for each dollar of earnings. Higher multiples go to businesses that are bigger, growing faster and less risky. Factors that typically push the multiple up or down:
| Higher multiple | Lower multiple |
|---|---|
| Larger EBITDA | Smaller EBITDA |
| Recurring, contracted revenue | Project-based or one-off revenue |
| Consistent growth | Flat or declining revenue |
| Diversified customers | A few customers make up most revenue |
| Strong management beyond the owner | Owner does everything |
| Low capital needs | Heavy ongoing capex |
| Attractive, growing industry | Declining or disrupted industry |
| Clean, well-documented financials | Messy or unaudited records |
Size matters a lot. A business with $5 million of EBITDA will generally command a meaningfully higher multiple than an otherwise similar one with $1 million, because it attracts more buyers, including private equity, and is seen as less fragile.
Where to find comparable multiples
- Business broker and M&A adviser market reports, which often publish median multiples by size band.
- Private market databases that track transactions.
- Public company multiples in the same industry, adjusted down substantially for size and liquidity.
- Conversations with intermediaries and lenders active in the sector.
Be cautious with published averages. They mix very different businesses. Use them as a range and place the specific business within it using the factors above.
Step 4: Calculate enterprise value
Enterprise value = adjusted EBITDA × multiple.
Continuing the example: our cleaning company has adjusted EBITDA of $1,275,000. It has a diversified customer base on annual contracts, modest growth and a capable operations manager, but the owner still holds key relationships. A buyer considers a range of 4.5x to 5.5x reasonable for a business of this size and profile.
Enterprise value range: $5.7M to $7.0M.
Step 5: Move from enterprise value to equity value
Enterprise value is the value of the business operations. What the seller actually receives depends on debt, cash and working capital.
Most small business deals are done on a cash-free, debt-free basis with a normalised level of working capital. That means:
- the seller pays off debt from the proceeds,
- the seller keeps excess cash,
- the business is delivered with an agreed "normal" level of working capital (receivables plus inventory minus payables), and the price adjusts up or down if actual working capital at closing is different.
Equity value ≈ enterprise value − debt + cash ± working capital adjustment.
The working capital peg is frequently overlooked by first-time sellers and can move the final price significantly. Agree how it will be calculated early, ideally in the letter of intent.
Step 6: Sense-check with cash flow
Before settling on a value, check that the business can support it. Calculate free cash flow (EBITDA minus capex, minus taxes, minus changes in working capital) and ask:
- Can the business service the debt the buyer plans to use, with comfortable headroom?
- How many years of free cash flow does the price represent?
- What happens in a downside case where revenue falls 15% to 20%?
If the deal only works under optimistic assumptions, the price is too high.
Common valuation mistakes
- Accepting the seller's add-backs without evidence.
- Using an EBITDA multiple on SDE.
- Using a single year's EBITDA when results are volatile.
- Ignoring capex needs in equipment-heavy businesses.
- Forgetting the working capital peg.
- Applying public company multiples directly to small private businesses.
Other valuation methods to cross-check
EBITDA multiples are the most common approach, but it's useful to check the result against other methods, especially when the business is unusual.
| Method | How it works | When it's useful |
|---|---|---|
| Discounted cash flow (DCF) | Projects future free cash flow and discounts it back to today | Businesses with predictable cash flows or significant expected change |
| Revenue multiple | Applies a multiple to revenue instead of earnings | High-growth or recurring revenue businesses with low current profits, such as software |
| Asset-based value | Values the business at the market value of its assets minus liabilities | Asset-heavy or underperforming businesses; sets a floor |
| Leveraged buyout analysis | Works out what a financial buyer can pay given debt capacity and target returns | Testing what private equity buyers are likely to bid |
If an EBITDA multiple suggests one value and a DCF or LBO analysis suggests something quite different, dig into why. The gap usually points to an assumption that needs a closer look, such as growth, margins or capital needs.
Strategic vs financial buyers
Who is buying affects the price. Financial buyers, such as private equity firms and search funds, are limited by their return targets and debt capacity. Strategic buyers, such as competitors or companies in adjacent markets, may pay more because they can capture synergies like cost savings or cross-selling. Sellers who can attract both types of buyer usually achieve better outcomes. Buyers should be aware of which type they're competing against.
Frequently asked questions
What is a good EBITDA multiple for a small business?
It depends heavily on size, industry, growth and risk. Smaller businesses typically sell for lower multiples than larger ones. Check recent market reports and comparable deals for your size band and sector.
What is adjusted EBITDA?
EBITDA corrected for items that won't continue under new ownership, such as above-market owner pay, personal expenses or one-off costs, and for missing costs a new owner would incur.
What's the difference between SDE and EBITDA?
SDE adds back one owner's full compensation to EBITDA. It's used for small owner-operated businesses, and multiples on SDE are lower than on EBITDA.
Is enterprise value the same as the sale price?
Not exactly. The seller's proceeds also depend on debt, cash and the working capital adjustment at closing.
Do buyers pay for future growth?
Partly. A growing business commands a higher multiple, but most buyers are reluctant to pay upfront for growth that hasn't happened. Earn-outs are often used to share the value of future growth between buyer and seller.