How a Business Is Valued for an SBA Loan (and What If the Price Is Higher)

Price versus value

The price is what you and the seller agree. The value, for an SBA lender, is what an independent valuation concludes the business is worth. In an SBA-financed acquisition, value matters because it caps the debt: the total debt supporting the purchase, including any seller note that isn’t on full standby, can’t exceed the business valuation, and it must also be supported by the business’s debt service coverage. If you agree to pay more than the valuation, the difference has to come from equity.

That’s why it’s worth understanding how a lender’s valuation works before you agree a price.

Who values the business

Under SOP 50 10 8.1, the business valuation comes from a “qualified source”: an individual who regularly does business valuations, holds one of several recognized valuation credentials, and is independent of the loan. The valuation must be requested by and prepared for the lender; a lender can’t rely on one prepared for the buyer or the seller. It states whether the deal is an asset or stock purchase and what’s included, gives a conclusion of value, and is signed.

For smaller deals, the SOP lets the lender do its own valuation when the business purchase price is $350,000 or less, unless there’s a close relationship between buyer and seller. The lender also checks the financial information the appraiser used against the seller’s IRS transcripts.

Real estate is separate. If you’re buying the building too, it’s appraised on its own, and its appraised value is taken out of the price to arrive at the “business purchase price” that drives the valuation and other diligence requirements. See buying your building.

Larger deals add a quality-of-earnings report. For initial acquisitions and business expansions with a purchase price of $3 million or more, a QoE is required in addition to the valuation, and its findings are used to calculate coverage. If that coverage doesn’t support the valuation and the proposed debt, the loan must be reduced. See quality-of-earnings review.

How small businesses are usually valued

Appraisers use several methods and reconcile them. For an operating small business, the market and income approaches usually carry the most weight:

• Market approach. What have similar businesses sold for, as a multiple of earnings? Small businesses are often quoted as a multiple of seller’s discretionary earnings (SDE); larger ones as a multiple of EBITDA. See valuation multiple and SDE.
• Income approach. What are the business’s expected future cash flows worth today, given the risk? In practice this leans heavily on normalized historical earnings.
• Asset approach. What are the assets worth? Relevant for asset-heavy businesses or as a floor; rarely the main method for a service business.

Whatever the method, the inputs are the same: normalized, verified, recurring earnings. Add-backs the appraiser won’t accept, customer concentration, dependence on the owner, a short or declining track record and thin documentation all push value down.

Where prices and valuations part ways

• Aggressive add-backs. The seller’s marketing package counts expenses the appraiser treats as real costs. See add-backs.
• “Pro forma” earnings. A price based on what the business will earn under new ownership. Valuations and the lender’s coverage test are built on history.
• Peak-year pricing. A multiple applied to the best year rather than a representative one.
• A multiple from a different size or industry. Broker rules of thumb don’t always fit.
• Owner dependence. A business that relies on the seller’s personal relationships is worth less to a new owner.

What you can do before the letter of intent

1. Ask for the tax returns early and compare them with the seller’s SDE or EBITDA figure. The gap tells you a lot.
2. Rebuild the add-backs yourself, using only what you could defend with documents.
3. Test the price against cash flow, not only a multiple. The acquisition calculator shows coverage at a given price and structure.
4. Build in a valuation contingency. A purchase agreement that lets you renegotiate or exit if the lender’s valuation comes in low protects your deposit.
5. Plan for the cost of the valuation, and of a QoE on larger deals, in your sources and uses.

For the broader process, see buying a business with an SBA loan. If you’re negotiating a price now, tell us about the deal and we’ll give you an honest read on whether the numbers are likely to support it.