How to value a small UK business

Key points

• Start from maintainable earnings: what the business earns in a normal year, not last year's headline profit.
• Normalise the accounts: remove one-offs and personal costs, and replace what the owner takes out with the market cost of the work they do.
• The multiple applied to those earnings reflects risk and transferability. It is specific to the business, not a sector rule.
• Valuation produces the value of the business itself (enterprise value). Cash, debt, working capital, deal terms and tax then decide what you receive.
• Several of the factors that move value are within an owner's control, but they take time to change.

What does "value" mean for a small business?

People use "value" for several different things, and mixing them up causes most of the confusion in early conversations about a sale.

• An indicative valuation is a reasoned range based on the information available today. It is the right starting point for planning: deciding whether to sell, when, and what to improve first.
• A formal valuation is prepared for a specific purpose with its own rules, such as a tax matter, a shareholder dispute or a legal process. It is commissioned for that purpose, from someone suitably qualified for it.
• The price is what a particular buyer agrees to pay, on particular terms, at a particular time. It is only known when a deal is agreed.

There is a second distinction: enterprise value, the value of the business itself, and equity value, what the shares are worth once cash, borrowings and other items are taken into account. This guide builds up to enterprise value first and then explains the bridge to equity value (Step 5).

Proplexo view: why a single number can mislead

A single valuation figure looks precise, but it rests on judgements: which year is "normal", which adjustments a buyer will accept, and how a buyer will price the risks. Present one number and those judgements disappear from view. The owner anchors on the figure, and every later offer is measured against it rather than against the reasoning.

A range, with the assumptions that drive each end of it, is more useful. It shows which factors matter most, which are open to challenge, and where better evidence or better performance would move the outcome. That is why Proplexo presents valuations as indicative ranges, with the reasoning set out.

How are most owner-managed businesses valued?

For a profitable, established owner-managed business, the most common approach is:

maintainable earnings × a multiple that reflects risk and transferability = enterprise value

The earnings figure answers "what will a new owner earn from this business in a normal year?". The multiple answers "how much is a buyer prepared to pay for each pound of those earnings, given how reliable and transferable they are?".

Other approaches suit some businesses better:

• Asset-based approaches may fit a business whose value lies mainly in property or other assets, or one that is not consistently profitable.
• Discounted cash flow values forecast future cash flows. It is used more often for larger businesses with dependable forecasts.

Our shorter guide on how owner-managed businesses are valued introduces these approaches. The rest of this guide goes step by step through the earnings-based approach.

Step 1: What are maintainable earnings?

Maintainable earnings are the profit a business can be expected to make in a normal year, under new ownership, without the owner's personal choices distorting the figure.

Last year's profit is rarely the answer on its own:

• A single year can be unusual. A large one-off contract, a bad debt or a move to new premises distorts it.
• The trend matters. Three years of steady growth tell a different story from one strong year after two weaker ones.
• The current year matters. A buyer will look at recent management accounts as well as the last filed accounts, and at whether the current year supports the historical picture.

What this means in practice: expect a buyer to look at the last two or three years and the current year to date. Be ready to explain any year that looks out of line. If trading is changing quickly, a buyer will want to understand which figure is genuinely maintainable, and will usually lean towards the more cautious view unless the evidence is strong.

Step 2: How do you normalise the accounts?

Normalised EBITDA is earnings before interest, tax, depreciation and amortisation, adjusted to show what the business would earn under a new owner. Owner-managed accounts reflect the owner's own arrangements, which a buyer will not inherit, so they need adjusting.

The common adjustments

• The owner's pay. Owners often take a modest salary and the rest as dividends, pension contributions or benefits. Dividends are not an expense in the accounts, so the reported profit may look higher than a buyer will actually earn. The robust approach is to add back all of the working owners' pay that runs through the accounts, then deduct the market cost of the work they do (see owner replacement cost, below). The result is then the same whatever mix of salary and dividends the owner chose.
• One-off income and costs. A legal dispute, an exceptional contract, a one-off insurance receipt, a restructuring. Remove them in both directions: one-off income comes out as well as one-off costs.
• Personal costs run through the business that a new owner would not incur.
• Related-party arrangements. Rent paid to the owner or their family for premises they own, or family members on the payroll. Adjust to a market rate where the arrangement will continue on different terms, or remove it where it will not.
• Discontinued activities that will not form part of the business going forward.

What is owner replacement cost?

If the owner works in the business, someone will have to do that work after a sale: the buyer, or an employee the buyer hires. Owner replacement cost is the market cost of that role, including employer costs such as National Insurance and pension contributions.

It is one of the largest and most debated adjustments in a small-business valuation, because it can move earnings by tens of thousands of pounds. The right figure depends on what the role actually involves (running a team, selling, managing finance, or all three), the size of the business and the location. Where more than one owner works in the business, each role is considered separately. A part-time owner is costed in proportion to the time they actually spend.

Every adjustment needs evidence

A buyer's due diligence will test each adjustment. Saying that a cost is personal or one-off is not enough on its own. The evidence is what a buyer can check: the entries in the accounting ledger, the invoices and receipts behind them, mileage or other supporting records, and contracts or correspondence relevant to the particular adjustment. Adjustments that cannot be verified are usually challenged, and each challenged adjustment reduces the earnings a buyer will pay for. A short schedule listing each adjustment, the amount, the reason and the supporting document makes the normalised figure far more credible.

Illustrative example A: from profit before tax to normalised EBITDA

Illustrative example. Company A is fictional. The figures are invented to explain the method; they do not represent any client or real business. No value is shown for Company A.

Company A is a fictional outsourced customer-service and administrative-support company serving small and medium-sized businesses. It has a turnover of about £1.4 million, a team of staff, and one owner who works in it full time, managing the team, the important client relationships and the finances. It holds no material stock and needs little equipment.

1. Profit before tax: £121,000.
2. Add loan interest (£4,000) and depreciation (£9,000): reported EBITDA £134,000.
3. Add back the owner's pay in the accounts (salary £35,000 and employer pension contribution £7,500, together £42,500): profit before owner's pay £176,500.
4. Add back personal costs (£8,500) and one-off legal costs (£11,000). Remove a one-off insurance receipt (£6,000). Adjust family rent to the market rate (−£6,000). Adjusted profit before owner's pay: £184,000.
5. Deduct the market cost of the owner's role, illustratively £65,000: normalised EBITDA £119,000.

What the example shows:

• Normalisation can reduce earnings as well as increase them. Company A's normalised EBITDA (£119,000) is lower than its reported EBITDA (£134,000), because the owner's pay in the accounts (£42,500) was below the market cost of the role, and the below-market family rent flattered profit.
• Dividends never appear. Whatever the owner took as dividends is irrelevant to the calculation; the owner's role is costed at market rate instead.
• The owner replacement cost is the biggest single judgement. A different view of what the role needs moves the answer more than any other line.
• Not every family salary is an adjustment. Suppose the owner's son works in the business in a genuine role at a market salary and will stay after a sale. There is nothing to adjust. The question is always what a new owner would pay, not who is being paid.

One caution on EBITDA: depreciation is added back when calculating EBITDA, but the need to keep replacing equipment does not go away. If a business has to spend regularly on vehicles, computers or machinery to keep trading, a buyer will take that recurring spending into account, even though it does not appear in EBITDA. For Company A it is small; for an equipment-heavy business it can be significant.

Step 3: Why do two businesses with the same profit sell for different amounts?

The multiple reflects how much a buyer is prepared to pay for each pound of maintainable earnings. Two businesses with identical normalised EBITDA can attract very different multiples, because a buyer is paying for future earnings under their ownership, and those earnings are more certain in one business than the other.

There is no single multiple that applies to every business in a sector or size band. Market evidence from comparable transactions provides a starting point. How that evidence should be read for a particular business depends on its earnings quality, how transferable it is, how concentrated its customers are, its scale and its other risks. Two businesses in the same sector and size band can therefore sit in quite different places. Published rules of thumb are a weaker guide still: they cannot reflect the strengths and risks of an individual business, and they are often based on asking prices rather than completed sales.

What supports value and what weighs on it

Revenue quality. Supports value: recurring or contracted revenue; long relationships. Weighs on value: one-off projects; revenue that must be re-won each year. A buyer will ask: how much of next year's revenue is already contracted or highly likely?

Customer concentration. Supports value: a broad customer base. Weighs on value: one or two customers providing a large share of profit. A buyer will ask: what happens if the largest customer leaves?

Owner dependency. Supports value: a team that runs day-to-day operations and holds key relationships. Weighs on value: the owner is the main salesperson, estimator and decision-maker. A buyer will ask: will customers and staff stay when the owner leaves?

Margin quality. Supports value: stable margins with a clear explanation. Weighs on value: margins that swing, or that depend on one supplier or price. A buyer will ask: why have margins moved, and are they sustainable?

Information quality. Supports value: reliable monthly management accounts that reconcile to the annual accounts. Weighs on value: annual accounts only; records that need reconstructing. A buyer will ask: can the numbers be relied on without rebuilding them?

Trend. Supports value: credible growth supported by past performance. Weighs on value: decline, volatility or a forecast with no track record behind it. A buyer will ask: is the forecast supported by what has actually happened?

Scale and buyer demand. Supports value: a size and profile that attracts several types of buyer. Weighs on value: a small or unusual business with few natural buyers. A buyer will ask: how many credible buyers would want this business?

Proplexo view: the drivers an owner can realistically change in 12–36 months

Not every driver is in an owner's hands. Sector conditions, the cost of borrowing and general buyer demand are largely outside them. Several of the most important drivers can be influenced over one to three years:

• Information quality is usually the quickest to improve. Monthly management accounts that are timely, reconciled and consistent with the annual accounts can be in place within months, and they affect how much of everything else a buyer is prepared to believe.
• Owner dependency takes longer. Building a team that holds customer relationships, prices work and makes day-to-day decisions needs time to show results that a buyer can see in the figures.
• Customer concentration and revenue quality can be improved gradually: wider customer bases, longer contracts, more recurring arrangements. A buyer will want to see the change sustained, not just started.
• A tidy balance sheet – settled disputes, overdue liabilities cleared, related-party arrangements put on a clear footing – removes points a buyer would otherwise price in or negotiate over.

The common thread is evidence over time. A change that has only just been made is a promise; the same change sustained over time is a track record.

Step 4: How do earnings and risk become a valuation range?

A valuation brings Steps 1 to 3 together: a view of maintainable earnings, and a view of how a buyer would price the risks and strengths of this particular business. Because both involve judgement, the honest output is a range.

• What narrows the range: a clear normal year, well-evidenced adjustments, reliable monthly information, and drivers that point in the same direction.
• What widens it: volatile trading, adjustments that are hard to evidence, heavy dependence on the owner or on a few customers, and limited information.

An indicative range is designed for planning. A formal valuation for a tax, legal or dispute purpose follows the rules that apply to that purpose, and should be commissioned specifically for it.

Step 5: Enterprise value vs equity value – what will you actually receive?

Earnings-based valuation produces an enterprise value: the value of the business itself, assuming it is sold with a normal level of working capital and without its cash or borrowings. What the owner receives for the shares is the equity value, and several items sit between the two:

• Cash. Cash beyond what the business needs to trade normally usually adds to the price.
• Borrowings. Bank loans, overdrafts, and hire purchase or finance lease obligations are usually deducted.
• Debt-like items. Some liabilities are treated like debt in negotiations, for example tax that is overdue rather than simply payable on its normal date, or other obligations that relate to the period before the sale. What counts is negotiated, and it is set out in the legal documents.
• Working capital. Deals usually assume the business is handed over with a normal level of working capital: broadly, normal trade debtors and stock less trade creditors and other agreed operating balances. The precise definition, and the normal level, are agreed for the particular transaction. If the level at completion is below the agreed normal level, the price usually falls by the shortfall; if it is above, the price may rise.
• Deal terms. Part of the price may be deferred: a fixed amount paid at agreed later dates. Separately, part may be conditional on future performance through an earn-out, so the amount is not certain at completion. Our guide to deferred consideration and earn-outs explains how these work.
• Costs and tax. Adviser fees and the tax on the sale reduce what you keep. Tax depends on your circumstances and the structure of the deal; your tax adviser can explain how it applies to you.

Illustrative example B: from enterprise value to equity value

Illustrative example. Company B is fictional, and a different business from Company A. Its enterprise value is a round figure chosen only to make the arithmetic easy. It is not derived from any earnings or multiple, and it says nothing about what Company A, or any real business, is worth.

1. Enterprise value agreed with the buyer: £1,000,000.
2. Add surplus cash (cash beyond normal trading needs): £120,000.
3. Deduct the bank loan (£150,000), hire purchase on vehicles (£30,000) and overdue tax (£25,000, a debt-like item agreed in negotiation).
4. Deduct the working capital shortfall: agreed normal level £110,000; actual at completion £90,000 – £20,000.
5. Equity value – the price for the shares: £895,000, of which £695,000 is paid at completion and £200,000 is deferred, payable over two years.

What the example shows:

• the headline figure in a heads of terms is often the enterprise value, while the seller receives the equity value;
• in Company B, £200,000 of the price is deferred consideration: a fixed amount simply paid later, not dependent on how the business performs;
• in other deals, some of the price may instead be conditional on future performance through an earn-out, which makes the amount uncertain as well as later;
• two offers with the same headline can therefore be worth quite different amounts, and carry different levels of timing and certainty.

What are the most common valuation mistakes owners make?

Proplexo view: common valuation mistakes

Each of these follows from the steps above, and each is avoidable with preparation:

1. Valuing on turnover. Turnover shows scale, not value. Two businesses with the same turnover can earn very different profits and carry very different risks.
2. Treating everything the owner takes out as profit a buyer will pay for. The work the owner does still has to be paid for after a sale. Ignoring owner replacement cost overstates earnings.
3. Assuming normalisation only adds to profit. It often adds back personal costs, but it can also remove one-off income, correct below-market arrangements and recognise the true cost of the owner's role.
4. Adding back costs a buyer will still incur. A genuine role at a market salary does not disappear because the owner changes. Nor does the need to replace equipment: depreciation is added back in EBITDA, but a buyer will still allow for the recurring capital spending the business needs to keep trading.
5. Using the best year as the normal year. A buyer will look at the trend and at the current year, and will ask why an exceptional year should repeat.
6. Anchoring on a figure heard elsewhere. A sale price reported for another business, or a sector rule of thumb, reflects that business and those terms, not yours.
7. Confusing enterprise value with what you will receive. Cash, borrowings, working capital, deal terms and tax all sit between the headline and the amount you keep.
8. Leaving adjustments unevidenced. An adjustment a buyer cannot verify is an adjustment a buyer is likely to reject.

How can you improve the value of your business before a sale?

Many of the drivers in Step 3 can be improved, but rarely overnight. Owners often benefit from beginning preparation 12–36 months before a planned sale:

• improve the quality and timeliness of financial information;
• reduce reliance on the owner and on key customers;
• strengthen recurring revenue;
• resolve issues before a buyer finds them.

Our exit readiness checklist sets out what to review, and our Exit Ready support is designed for this preparation.

Working out your own position

A practical sequence for an owner who wants a first view:

1. Gather three years of accounts and the current year's management accounts. Note anything unusual in each year.
2. Calculate profit before owner's pay. Start from profit before tax, then add back interest, depreciation and the working owners' pay that runs through the accounts.
3. List every normalisation adjustment, with its evidence: personal costs, one-offs (in both directions) and related-party arrangements.
4. Estimate the market cost of each working owner's role, based on what the role genuinely involves.
5. Review the drivers in Step 3 honestly. For each, ask what a buyer would ask and what evidence you could show.

That gives you a well-founded view of your normalised earnings and of the factors a buyer will focus on. Turning it into an indicative valuation range needs a view on how buyers would price those factors for a business like yours. How Proplexo Value works explains the method behind our free indicative valuation tool, including its limits.

How Proplexo can help

Our Strategic Valuation Review provides an indicative valuation range for your business, based on normalised earnings, together with the factors that could improve it. It helps you decide whether to sell now or build value first.

This article is general information for owner-managed businesses, not advice on your circumstances.