Small business valuation methods for an owner about to list: three checks on one bakery

How much do small business valuation methods disagree on one company?

On our hypothetical bakery they disagree by millions: the earnings multiple gives about $3.2 million, the asset-based method gives a $900,000 floor, and discounted cash flow lands anywhere in between depending on the discount rate. Which one sets the price depends on how far earnings run above assets.

Meet Latoya, 51, divorced, owner of a wholesale bakery that supplies regional grocery stores. Her daughter is heading to college. A competitor's letter of intent offers $3.2 million, with 30 percent paid as an earnout, and her only other savings are about $550,000 in a solo 401(k).

Rule of thumb for placing yourself: if earnings times the multiple comes out below the asset floor, the asset-based method sets your price. If it comes out well above, the gap is goodwill, and goodwill is where the tax questions start.

No IRS-published multiple exists. Buyers set it from comparable sales and from risk, and for Latoya the risk is two or three grocery chains buying most of her bread. Treat discounted cash flow as a cross-check, because a small change in the discount rate or growth assumption swings the answer by hundreds of thousands.

Placing yourself between the floor and the multiple

Step 1: Gather three years of returns and the depreciation schedule

Start with paper. Ask your CPA for three years of business returns (Form 1120-S, Form 1065 or Schedule C). Ask the bookkeeper for year-end profit-and-loss statements and balance sheets, and pull the receivables aging report from the accounting software.

Then get the fixed-asset register or the Form 4562 depreciation schedule. Add your own W-2, so a buyer can compare your salary with what a hired manager would cost. Collect invoices for any one-time repairs you plan to add back, plus the supply contracts with the grocery chains, since buyers ask how much revenue the top customer brings in.

Decide which years the buyer will see. Most buyers want the last three, and a strong year two years back rarely helps if last year slipped.

The slip here is handing over internal statements that don't tie to the filed returns. A buyer who finds one gap starts doubting every add-back that follows, and Latoya's add-backs are where $100,000 of her earnings comes from.

What to gather and where

The slip at this step

Step 2: Read the IRS fair market value rule as written

The wording comes from Treasury Regulation 20.2031-1(b), applied to businesses through Revenue Ruling 59-60: fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither under compulsion and both with reasonable knowledge of the relevant facts.

Revenue Ruling 59-60 lists factors to weigh, such as earnings capacity, book value and sales of comparable businesses. It gives no formula.

Owners paraphrase it as 'the IRS uses five times profit' or 'it's worth whatever the offer says.' Neither is the rule. An arm's-length offer like the $3.2 million letter of intent is real evidence of value. But the earnout portion, 30 percent or $960,000, is contingent on future results, so it is worth less than the same sum paid in cash at closing.

Latoya's cash value today is the other 70 percent, $2.24 million. Anything above that depends on the bakery performing for a new owner.

What the rule says

What the offer proves

Step 3: Rebuild earnings with add-backs you can prove

Latoya, a hypothetical person, 51, has reported bakery EBITDA of $540,000 and $100,000 of add-backs: $60,000 of salary above a market manager's pay, a $25,000 one-time oven rebuild and $15,000 of personal car and phone costs. Adjusted earnings are $540,000 + $100,000 = $640,000. At five times earnings that is $3.2 million, which supports the offer.

A buyer who strikes the undocumented $15,000 sees $625,000 × 5 = $3,125,000, or $75,000 less. Our calculator runs the same arithmetic on your own figures.

The tax angle matters here. IRC section 162 allows only ordinary and necessary business expenses. An add-back for personal costs tells the buyer, and anyone else reading the file, that those deductions were personal. Moving them off the books is the clean fix, even though it raises income tax.

Timing changes the cost. Say Latoya cleans the books now and sells in two years. The $15,000 shows up in reported earnings on two filed returns, at a tax cost of about $4,500 per year (30 percent assumed, for illustration), so $9,000 total, for $75,000 of price. If she waits five years, the same fix costs $22,500 in tax for the same $75,000, plus three more years of business risk.

Before Apollon Wealth Management suggests listing, it rebuilds the earnings number this way, so the owner sees the price a skeptical buyer would pay. The decision rule is plain: in your own estimate, count any add-back you cannot tie to a filed return, a W-2 or an invoice at zero.

One caution. These methods give a planning range, not a formal appraisal, and a buyer's quality-of-earnings report can still move the number.

The numbers, step by step

Clean now or clean later

Step 4: Price the asset floor at market value, not book value

Fully depreciated ovens and mixers show near zero on the depreciation schedule but may still sell for real money, so hire an equipment appraiser before you quote a floor. For the hypothetical bakery, $900,000 of tangible assets at market value sets the floor. Anything the multiple produces above it is goodwill. The decision at this step is who pays for the appraisal and when; the slip is skipping it and trusting book value.

Step 5: How much of the price is taxed as ordinary income?

Ordinary income covers gain on equipment up to the depreciation you already took, plus any payment labeled non-compete or consulting. Goodwill held more than a year is generally taxed as capital gain. In an asset sale, buyer and seller each file Form 8594 under IRC section 1060 to split the price across asset classes.

Goodwill is the residual, so it absorbs whatever the equipment and inventory don't. Stock sales work differently, and another page of ours covers asset versus stock structure.

Ask of every move whether it shifts tax or saves it. Putting a higher value on the equipment gives the buyer bigger deductions and gives you more ordinary income, so the tax moves onto you. Cleaning up personal expenses is the move that pays: about $9,000 of tax cost for $75,000 of price.

Watch the goodwill row grow in the table while the asset floor stays flat. The more of the price that is goodwill, the more the allocation on Form 8594 matters.

Sale prices and earnouts are never certain, and a bakery's value can fall before closing, so treat every row as a range.

Which dollars are ordinary income

Shift or save

Step 6: When your daughter asks what the bakery is worth

The CPA usually raises add-backs first, but at home it's often the teenager heading to college who asks the blunt question. Latoya can answer with a range, not one hoped-for number: asset floor $900,000, earnings value about $3.2 million, and $2.24 million in cash at closing if the earnout pays nothing. A range is honest, and it gives her daughter something she can plan around too.

Undocumented add-backs and book-value floors, two slips that travel together

Slip one: listing the $15,000 of personal car and phone costs as an add-back with no records, while the filed returns still deduct them. A buyer's quality-of-earnings report strikes it, and at five times earnings that is $75,000 off the price.

Slip two: quoting the asset floor from the depreciation schedule instead of an appraisal. That understates the fallback value and weakens the owner's position when the buyer pushes more of the price into the earnout, where $960,000 already depends on future results.

Together they cost $75,000 off the headline price and leave more of the remainder at risk. Fix the first with records or by moving the costs off the books, and the second with one appraisal.

Related pages cover the next decisions: a letter of intent checklist for a sale, and buy-sell agreement funding if partners are involved. Health coverage before 65 and key person insurance also come up once a deal is close.

How the two slips add up

Bringing your valuation range to Apollon Wealth Management

Apollon Wealth Management advisors can lay the three methods side by side against your own returns and depreciation schedule, then list the decisions in order of deadline: books to clean this year, an appraisal before listing. Every fee is written into the client agreement, and no charge outside it applies. To begin, describe your situation on the form on this page; we meet by phone or video.