In valuing closely held businesses for SBA 7(a) financing, determining an appropriate cost of equity is a critical step in the income approach. This white paper explores the application of the build-up method using current Kroll data, historical returns by asset class, and empirical investor return expectations. Additionally, it addresses practical challenges and offers recommendations for robust application.

Overview of Required Returns Across Asset Classes

Historical data on asset class returns provides a benchmark for setting the floor of expected equity returns:

• U.S. Large-Cap Stocks (S&P 500): ~10%
• U.S. Small-Cap Stocks: ~12%
• Long-Term Government Bonds: ~5–6%
• T-Bills (Risk-Free Rate Proxy): ~3–4%
• REITs: ~9–11%
• Private Equity Funds: ~15–20%+
• Venture Capital: ~20–30%+
• Angel Investments: ~25–35%+

The Build-Up Method for Estimating Cost of Equity

The build-up method is widely used for private company valuation as it avoids reliance on beta. The formula is:

Cost of Equity = Risk-Free Rate + ERP + Size Premium + CSRP

Note: The historical equity risk premium (ERP) of 7.31%, as reported by Kroll, is used in this valuation context. This figure is grounded in over a century of market data and is preferred in many private business valuations for SBA 7(a) loans because it reflects actual, observed investor returns across market cycles. While Kroll also offers a lower supply-side ERP (~5.8%), the historical ERP is more appropriate here due to its alignment with investor expectations in the lower middle market and its incorporation of valuation re-ratings and real-world capital behavior.

Justification for 10z Size Premium

Kroll reports the size premium for the smallest decile of public companies (10z) at 10.57%. This is appropriate for private company valuations under SBA 7(a) standards due to similar size, liquidity, and operational risks.

Historical ERP vs. Supply-Side ERP

The choice between these ERPs has significant implications. The supply-side ERP attempts to remove the effects of valuation expansion (e.g., P/E multiple increases), which some view as unsustainable. However, for SBA 7(a) valuations of private companies, which tend to have higher risks, greater illiquidity, and less predictable cash flows, the historical ERP offers a more conservative and practical foundation.

Real-world investors—including angel investors and private equity sponsors—often base their return expectations on actual historical returns, not on academically adjusted models. Thus, using the historical ERP ensures consistency with what a market participant might realistically demand.

Kroll provides multiple ERP options. While the supply-side ERP (~5.8%) is used in many public company valuations, the historical ERP (~7.31%) is often more appropriate for private companies. It reflects real-world investor behavior and return expectations, especially in the lower middle market.

Practical Challenges in Applying the Build-Up Method

Valuation professionals may encounter several challenges when estimating the cost of equity using the build-up method:

• Selecting the CSRP: Determining an appropriate company-specific risk premium (CSRP) is subjective and requires justification, as it can significantly impact the final cost of equity.
• Data Availability: Reliable data for small private companies is often limited, making it difficult to align the 10z size premium or ERP with the company’s specific risk profile.

Build-Up Example

For a private company:

• Risk-Free Rate: 4.5%
• Historical ERP: 7.31%
• Size Premium (10z): 10.57%
• CSRP: 0–15%

Resulting in a Cost of Equity range: 22.38% – 37.38%

Relevance to SBA 7(a) Valuation and Lending

A cost of equity in the 20–40% range aligns with expected returns of private equity, venture capital, and angel investors. This helps support discount rates or cap rates applied to small private companies in SBA 7(a) lending contexts, ensuring valuations reflect market participant expectations.