Common Errors in SBA Business Valuations: A Practical Checklist for Lenders

As SBA loan default rates rise, it is increasingly important for lenders to ensure that business valuations supporting SBA loans are well‑reasoned, internally consistent, and reflective of the business’s actual ability to service debt as of the valuation date.

While there are many reasons a loan may ultimately default, overpaying for a business materially increases the likelihood of failure. An inflated valuation places immediate pressure on cash flow, limits borrower flexibility, and creates an uphill battle for a new owner from day one.

1. Reconciliation of Values

This is an extremely simple one and easy to check. Generally, a business valuation for SBA purposes will rely on an income and market approach to determine the business’s fair market value. Equal weighting of these methods is reasonable only if the two approaches converge.

Let’s examine the following valuation conclusion:

Here, the concluded value is $1,500,000, despite a 100% difference between the two methods.

A helpful analogy is residential real estate. If an agent produced two comparable sales, one at $1,000,000 and one at $2,000,000, and suggested listing the home at $1,500,000, most sellers would pause.

The differences among these methods cannot be addressed simply by equal weighting. Such divergence in values usually signals a problem, including:

Inappropriate assumptions in one or both methods, or
That one method is materially less reliable for the subject business

For SBA loans, this issue is especially concerning because the income approach most closely aligns with debt service capacity. If the income approach supports $1,000,000, concluding at $1,500,000 implies a 50% overstatement relative to cash flow and a significantly higher default risk assuming the buyer purchases the business for $1,500,000.

Check #1: Ensure valuation methods converge within a reasonable basis. A divergence of about 10-15% between the methods is typically reasonable, but anything larger warrants greater scrutiny and a clear justification within the business valuation.

2. Paying for Potential

“I have five businesses and have not really been focused on this business, but with the right efforts, this buyer could really unlock a lot of value.” This is a common narrative, but one that lenders should treat cautiously.

Using the real estate analogy again, a neglected home does not sell for the same price as a well‑maintained one simply because it could be improved. Buyers expect to be compensated for the time, capital, and risk required to make those improvements.

When a business shows declining performance, assigning value based on future improvements creates significant risk. The buyer must now:

Execute operational improvements, and
Service debt that was underwritten to a future level of performance

This is particularly problematic because it is often challenging to determine, or downright impossible, whether declines are due to:

Temporary owner disengagement, or
Structural weaknesses in the business model

Check #2: Is the value of the business based upon its historical performance or projected improved performance that has not yet occurred? If a lender is considering using Investment Value, they should be aware of the valuation implications.

3. Equal Weightings of Historical Periods

This ties into the point regarding a buyer “paying for potential”.

Let’s say these are the three years being considered:

While not related to free cash flow, the Seller’s Discretionary Earnings (SDE), which equals EBITDA plus Owner’s Compensation, can generally be viewed as free cash flow to service debt in a worst-case scenario in which the owner forgoes compensation. This would not be ideal, but we are stress testing against a worst-case scenario.

If a valuation were to weight the years equally, the implied SDE would be $400,000. Let’s assume an SDE multiple of 3x.

Using equal weights doubles the final value, even though there is a clear downward trend.

Unless there is a well‑supported explanation for why performance will rebound, weighting stronger, less recent, historical years equally can materially overstate value and leave the borrower unable to service debt if results remain at the most recent levels.

Equal weighting may be appropriate in cyclical industries, but in the absence of a credible explanation, declining trends should be weighted accordingly.

Check #3: Do the historical weightings reasonably reflect the business’s current operating reality and likely near‑term outcomes?

4. Use of Revenue Multiples

Under the market approach, appraisers will typically use the transaction method, which involves deriving pricing multiples from similar small businesses that have been sold. The contemplated multiples are usually based on revenues and SDE. Careful consideration is needed when applying a revenue multiple.

Consider the following two companies:

All else equal, under an income approach, the value of Company A is going to be greater than that of Company B. However, if an appraiser applied a 1x revenue multiple to both companies, they would arrive at the same value for both businesses. This is often where the divergence in values, as discussed in point #1, arises from. The revenue multiple applied does not account for the company’s earnings potential or its future ability to repay debt resulting from the transaction.

This concern could be partially mitigated if the business valuation uses an SDE multiple, but if both multiples are weighted equally, we arrive at the issue raised in point #1 again. We have weighted two diverging values, and the resulting weighted value is not more reliable.

Consider the scenario where both companies have a 1x revenue multiple and a 3x SDE multiple applied:

As shown above, Company B’s performance warrants a lower revenue multiple. However, if these values are weighted equally, the appraiser would conclude that Company A is worth $950,000 and Company B is worth $650,000. If Company B is purchased for $650,000 but only produces $100,000 in income before owner’s compensation, it will be challenging to service that debt, increasing the probability of default.

Check #4: Ensure any value derived from a revenue multiple reconciles with the value derived from cash flow-based metrics, particularly SDE.

Final Thoughts

A well‑prepared business valuation should support a lender’s credit judgment, not obscure risk through unsupported assumptions, mechanical weightings, or reliance on “potential.”

By applying the checks outlined above, lenders can quickly identify common valuation red flags and reduce the likelihood that an inflated purchase price undermines an otherwise sound SBA loan.