Understanding SMB valuation multiples

Deciding on what to pay for a business is a complex task. How do you determine a fair price to pay relative to the company’s profitability and other comps on the market?

Questions such as these can be answered by using valuation multiples. Here’s how they work.

What are valuation multiples?

Valuation multiples is a tool to help standardize the valuation of a business so buyers and investors understand the price they are paying for a unit of financial performance. For instance, if you’re purchasing a car wash business and the seller is listing their business for an earnings (or, EBITDA) multiple of 3x, this means they want three times the amount of their (typically, past twelve months) earnings.

The core idea, according to Main Street Securities investment banking representative Wade Bruffey, is this: “Valuation multiples are a way of valuing an asset.” More specifically, Bruffey says that multiples are a way of “putting a value on the steam of cash [a] business is generating.”

The type of multiple used also depends on precedent transactions—previous purchases in similar industries that are comparable to the business in question and the buyer’s intention. For instance, a company that is VC-backed might use a revenue multiple to start negotiating a purchase price, because profitability isn’t a fair indicator of its value. Much of the reasoning behind which multiple is used in a given transaction—and its magnitude—comes from previous transactions involving similar companies.

In small business acquisitions on Main Street, normally the multiple used is on adjusted EBITDA or sellers’ discretionary earnings. These two multiples provide buyers with a way to get close to an “apples-to-apples” comparison between two businesses within the same industry, by looking at how much the purchase price is in comparison to the earnings that the business generates. A higher multiple means you’re paying more for each dollar of earnings. But, sometimes that is for good reason (e.g., the business is larger and thus more stable, they have long-term contracts with customers, etc).

The intention of the buyer is also an important factor when it comes to suggesting a valuation multiple. If a purchaser is a strategic buyer rolling the business into their portfolio, they might have more tolerance for a higher price—they have additional cash-flowing businesses that benefit from the purchase. Financial buyers who are planning on only being in the company for 5-10 years might have a lower tolerance to higher multiples, given their shorter lifespan in the company.

What business factors affect a multiple?

The size of a company’s valuation multiple is dependent on a number of characteristics, including:

• Size. Typically the larger a business, the harder it is for its cash flow to be seriously disrupted—barring any major negative events. The greater the size of a business, the greater the size of the valuation multiple. 

• Seller motivation. Multiples are a negotiable instrument, so the seller’s motivation to exit can impact them substantially. For instance, if a seller is nearing retirement age and wants a fast exit to use their sale proceeds quickly, they may settle for a lower multiple than a seller willing to spend more time on the market.

• Market position. A business that has a grip on a market typically demands a higher multiple. This is largely due to asset defensibility. If a business has a high barrier to entry or it is hard to compete with, the seller will expect a higher purchase price to take that defense characteristic into account. This comes back to asset performance: the better a business can reliably generate cash flow, the higher multiple used.

• Revenue mix. Typically if a business has recurring revenue (e.g., contracts that generate annual revenue), that business will trade at a higher multiple than a business with “reoccuring” or project-based revenue. The rationale is that there is less work required to keep the business at the same revenue or earnings level – the owner doesn’t have to rebuild the funnel each quarter from scratch.

• Competition. Congestion among buyers to purchase a business increases competition. This can increase the multiple used to determine the purchase price. More aggressive multiples may be offered by multiple buyers to dissuade competitors from engaging. This is common in industries with lots of private equity activity (e.g., pest control).

• Industry. The type of business under consideration greatly affects the multiple used. For example, according to Pepperdine Private Capital Markets Report, businesses in the manufacturing sector had an average deal multiple of 7.4.

Source: Pepperdine Private Capital Markets Report - 2024

How do valuation multiples affect purchase price?

A valuation multiple represents a multiple earnings—or other financial metric like revenue—to come to a final purchase price. 

For example, let’s say a car wash generates an EBITDA of $250,000. Using an EBITDA multiplier of 5.5x, the car wash would have an implied value of $1,375,000 (250,000 x 5.5 = 1,375,000).

Note that multiples change throughout the buying and selling process. While a buyer may suggest a multiple to be used, the seller may return with a lower multiple after reviewing additional financial data or other precedent transactions.

Types of valuation multiples used with SMBs

Valuation multiples come in myriad types. Here are some of the most commonly used ones when it comes to SMB acquisitions.

Seller’s discretionary earnings (SDE) multiple

SDE refers to the amount of funds a business “could theoretically distribute,” says Bruffey, adding “If I took 100% [cash] out of this [business] each year, what would that be? That’s SDE.” Said a different way, SDE represents the total owner’s financial benefit, including their salary, bonuses, and other personal expenses paid for by the business. 

SDE is most often used in smaller transactions, as EBITDA—or adjusted EBITDA—becomes a more reliable measure of a company’s value as the company grows. 

The SDE multiple used depends on the size of the business. For instance, a business with SDE of $350,000 to $500,000 could use a multiple of 2x to 3x. A business with SDE in the $1,000,000 range may use a 4x+ multiple.

Adjusted EBITDA multiple

SDE and adjusted EBITDA are nearly identical valuation multiple types—both measuring the cash flow of a business. That said, adj. EBITDA typically includes negative add-backs and does not add-back the owner’s entire salary, just the difference between their salary and that of a replacement. 

Let’s say you purchase a smaller business, and the Head of Sales decides to exit with the previous owner. In SDE, you would adjust for the cost of replacing the Head of Sales but not the owner. In adj. EBITDA, you would adjust for the cost of replacing the Head of Sales as well as the salary required to attract a manager to take on the owner’s responsibilities. 

Discretionary expenses or owner perks are also considered adjustments. Below is an example Adj. EBITDA calculation.

Adj EBITDA multiples may range anywhere from 4x to 6x depending on the cash flow and industry of the business. 

EBITDA multiple

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is arguably the most common valuation multiple used in M&A. It is a reliable, non-GAAP measurement of a business’s cash flow or ROI that normalizes differences and may provide a more accurate projection of future cash flows. In other words, EBITDA is a proxy for cash flow.

Among SMB purchases, EBITDA multiples range greatly depending on the size of the business and other factors—such as the ones discussed above. According to Pepperdine’s Capital Private Markets Report for 2024, the average EBITDA multiple across all industries and business size was 6.9x. Businesses with an EBITDA of $1 million averaged a multiple of 5.3x, whereas $100 million EBITDA businesses commanded an average multiple of 10x.

Revenue multiple

Though revenue multiples are sometimes used, they tend to be very uncommon in the SMB world. This is largely due to revenue not accounting for costs, unlike EBITDA or SDE metrics. Businesses that are highly specialized (e.g. SaaS) or in “high-growth” mode may more frequently use revenue multiples. However, Bruffey has completed over 25 transactions over his career and, “none of them have been on a revenue multiple,” he told Mainshares.

Part of the reason for the lack of revenue multiple used in SMB transactions is due its lack of applicability. SMBs likely won’t have investor backing or be extremely high growth spurts. Revenue multiples are better used for companies with those characteristics as profitability isn’t as much a priority in the short-term, necessarily.

Revenue multiples in the SMB world are relatively small compared to EBITDA multiples: average revenue multiples range between 0.5x and 2x.

How a buyer might come to a valuation multiple

The exact steps a buyer takes to get to a valuation multiple varies greatly from deal to deal. That said, below are some common steps that occur when buyers are looking to ascertain a fair purchase price on a target business. Note that these steps don’t necessarily happen in a chronological fashion.

• Define your acquisition or investment thesis: A buyer first wants to create their “buy box”— a set of industry and company-specific requirements they’re looking for in their ideal acquisition or investment.  

• Market research. The buyer then researches the market for precedent transactions and the multiples used in past deals. This gives them an idea of what type of multiple range they can expect to pay. 

• Create a financial model: A buyer may use a financial model to determine potential future cash flows and how likely it is the business may succeed after the purchase. A common financial model used is discounted cash flow (DCF), which is a forecast of a company’s free, unlevered cash flow reduced back to today’s value. 

• Negotiate. After gathering as much relevant information, the buyer approaches the business with a proposed valuation. Both the seller and the buyer negotiate back and forth to come to a fair valuation (and corresponding multiple) that represents each of their interests. 

• Execute an LOI. Once a purchase price is agreed upon, the parties sign an LOI and begin further due diligence. 

Cautions of valuation multiples in SMB deals

Unlike the stock market, where every company reports earnings in a uniform accounting framework (i.e., GAAP) and there are many companies to compare and contrast, the private markets on Main Street are a lot less standardized and more opaque. 

There is no “stock market” that reports the past transactions and their multiples, only a few databases you can license with self-reported data. There are rarely audited financials, meaning owners may report earnings differently from business to business.

This means that most small business buyers approach purchase price from a debt-service coverage perspective (e.g., how much can I pay and still have a decent buffer after repaying debt, my salary, and other expenses?) vs. a multiple perspective. 

Conclusion/Bottom line

Valuation multiples are key to evaluating different businesses to acquire and are based on a business’s size, precedent transactions, defensibility, industry, and market position, among other factors. As a negotiated financial tool, valuation multiples help buyers and sellers find a purchase price that has precedent-backing and is fair in terms of financial fundamentals and market competition. 

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