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How do you know how much a small business is worth? If someone were to sell their bed and breakfast (for argument sake), how would they know how much it's worth? ... or more importantly, how would a potential buyer know how much to pay for it?

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I don't have any experience in this, but this is my academic understanding of business pricing.

The LOWEST amount a seller would accept is the liquidation value. For a B&B, what would the value of the land, the house, the furnishings, accounts payable, etc. be if it had to be sold today, minus any liabilities.

The amount the seller would like to pay for is going to be a multiple of its annual earnings. One example of this is the discounted cash flow analysis. You determine the EBITDA, the earnings a company generated, before interest, depreciation, taxation and amortization.

Once you have this amount, you can project it out in perpetuity, or you use an industry multiplier.

Perpetuity:

You project this value out in perpituity, discounted by the going interest rate. In other words, if you project the business will earn $100,000/year, the business should grow at a 5% rate, and the going interest rate is 8%. Using a growing perpetuity formula, one value of a business would be:

100,000 / (.08 - .03) = $2,000,000.

This is a very high number, and the seller would love to get it.

It's more common to do a multiple of the EBIDTA. You can do some research into the valuation of the particular industry to figure out the EBIDTA multiplier for the industry. For example, this article suggests that the 2011 EBITDA multiplier for hospitality industries is 13.8. (It's valuing large hotel chains, but it's a start). So the value of this B&B would be around $1,380,000. Here is an online SME valuation tool to help with the EBIDTA multiple based valuation.

Also, from my research, it looks like many small business use Seller Discretionary Earnings (SDE) instead of EBITDA. I don't know much about it, but it seems to serve a similar purpose as EBITDA.

A potential buyer should request the financial statements of the business for the last few years to determine the value of the business, and then can negotiate with the owner a price. You would probably want to enlist a broker to help you with the transaction.

  • For the B&B specifically, I've heard that owners underestimate their own time value. In other words, they claim to take a fair salary, but are working 18/7. This comment is anecdotal, no citation. – JoeTaxpayer Mar 15 '13 at 12:37
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    Where the .03 in the formula came from? – emanuele Feb 24 '14 at 18:48

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