The 3-2-1 weighting protects a buyer when earnings rise and works for the seller when they fall. What it replaces is evidence about the latest year.
A weighted average of SDE gives the latest year a weight of 3, the year before 2 and the oldest 1, then divides by 6. On an illustrative business whose SDE grew from 380,000 to 420,000 to 500,000, the weighted figure is 453,333, so at 2.8 times the price is 1,269,333 rather than the 1,400,000 the latest year alone supports. If the same three years run the other way, the weighting flatters the seller: 413,333 against a latest year of 380,000.
Worked in full in Buying a Small Business by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Brokers price on the latest year when earnings are rising and on an average when they are falling; buyers do the opposite. Neither is a method. The weighting is a stand-in for an answer to a single question, what the business will earn in the first year you own it, and it should be replaced by evidence wherever evidence exists.
| Year | SDE, growing case | SDE, declining case | Weight |
|---|---|---|---|
| Oldest | 380,000 | 500,000 | 1 |
| Middle | 420,000 | 420,000 | 2 |
| Latest | 500,000 | 380,000 | 3 |
The multiple is 2.8 times SDE in both cases. The SDE figures are taken as already verified: personal expenses, one owner's salary and genuine one-offs added back, the rest disallowed, as in valuing a small business on a multiple of SDE. Weighting unverified figures only averages the errors.
Simple average = (380,000 + 420,000 + 500,000) ÷ 3 = 433,333
Weighted average = (3 × 500,000 + 2 × 420,000 + 1 × 380,000) ÷ 6 = 2,720,000 ÷ 6 = 453,333
Value = 453,333 × 2.8 = 1,269,333
Excel: =SUMPRODUCT(SDE,{1,2,3})/6*Multiple, with the years in date order
The weights are 50.0, 33.3 and 16.7 per cent. The latest year is 46,667 above the weighted figure, which at 2.8 times is 130,667 of price, 10.3 per cent more than the weighted value. Put another way, paying 1,269,333 for the latest year's 500,000 is a multiple of 2.54 times, and that is how the gap usually gets negotiated: not as a different SDE but as a lower multiple on the seller's number.
| Basis | Growing: SDE | Value | Declining: SDE | Value |
|---|---|---|---|---|
| Latest year | 500,000 | 1,400,000 | 380,000 | 1,064,000 |
| Weighted 3-2-1 | 453,333 | 1,269,333 | 413,333 | 1,157,333 |
| Simple average | 433,333 | 1,213,333 | 433,333 | 1,213,333 |
With a steady trend the weighting lands between the latest year and the simple average, so it protects the buyer only when earnings are rising. In the declining case SDE fell 16.0 per cent and then 9.5 per cent; a 3-2-1 average prices the business 93,333 above its latest year, 8.8 per cent too high, on the assumption that some of the old earnings will come back. A buyer should ask what would bring them back. If nothing would, the latest year, or a forecast below it, is the honest base.
The growing case had a 19.0 per cent jump in its final year, after 10.5 per cent the year before. Suppose diligence finds that 60,000 of it came from a single contract that will not repeat. Remove it and the latest year is 440,000:
| Basis | SDE | Value at 2.8x |
|---|---|---|
| Latest year, as listed | 500,000 | 1,400,000 |
| Weighted, as listed | 453,333 | 1,269,333 |
| Latest year, adjusted | 440,000 | 1,232,000 |
| Weighted, adjusted | 423,333 | 1,185,333 |
The adjustment is worth 168,000 at the latest-year price, more than the whole effect of weighting. This is the general pattern: a weighting is a blunt discount for not knowing why the last year was good. Once you know, adjust the line itself and price on the result.
| Multiple | Latest year | Weighted 3-2-1 | Simple average |
|---|---|---|---|
| 2.5x | 1,250,000 | 1,133,333 | 1,083,333 |
| 2.8x | 1,400,000 | 1,269,333 | 1,213,333 |
| 3.2x | 1,600,000 | 1,450,667 | 1,386,667 |
The mistake is using the weighting in one direction only. Buyers reach for 3-2-1 when the trend is up and forget it when the trend is down, at which point it works for the seller. The second mistake is mixing bases: the multiple from a comparable sale was almost always applied to that business's latest year, so applying it to a weighted figure is a discount on a discount. Use the latest year with the multiple, and argue about the multiple, or use a weighted figure with a multiple you have derived on the same basis. The lender, for its part, will test coverage on the latest year and the trailing twelve months, which is the stricter check in a decline.
The seller's three years, the broker's add-backs and the quality of earnings are laid out line by line in the free workbook for this case.
On what the business will earn in your first year, which is usually the latest verified year adjusted for anything that will not repeat. Averages are a fallback when the trend cannot be explained. At 2.8 times, a latest year of 500,000 gives 1,400,000, a 3-2-1 weighted 453,333 gives 1,269,333.
It depends on the trend. With SDE rising to 500,000 the weighting lowers the base to 453,333 and helps the buyer. With SDE falling to 380,000 it raises the base to 413,333, 8.8 per cent above the latest year, and helps the seller, by 93,333 of price at 2.8 times.
Divide the weighted value by the latest year's SDE. A 1,269,333 price, 2.8 times a weighted 453,333, is 2.54 times a latest year of 500,000. Negotiations usually settle there: on the seller's SDE with a lower multiple, rather than on a different SDE.
This article is one calculation from Buying a Small Business. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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