What Drives the Value of Your Business?
It’s not uncommon for business owners to be surprised how potential buyers value their business, and it’s important to understand how and why buyers assess a given business the way they do.
For a buyer, cash flow is king. A buyer must: 1) Pay themselves; 2) Service any acquisition debt; 3) Earn a return on their investment.
Sellers often hope there will be a magical buyer with more money than sense, or that their business in particular has some special “it factor” that will induce buyer’s to pay a hefty premium. That is seldom true in smaller businesses. Every buyer wants to earn an appropriate return for the risk they are taking.
What creates value in a business is the same as any investment: its ability to earn a return for the investor. An owner might say, “But we have a great logo and website!” or “We have the best reputation in the industry!” In terms of value, though, how much money do those things make? I.e., what return do they earn?
The point isn’t that these things don’t have value—they do! A lot in fact—but these things are the reason why your business makes the money it does and is attractive to a buyer. A great reputation that makes a million dollars a year is worth more than an equally great reputation that makes $50k a year.
The condition of your equipment is another factor. Suppose two identical businesses each make $2 million, but business A’s equipment is worn out and needs a $500,000 investment and Business B’s equipment is new and up-to-date. Business B will be worth more (or A worth less) based on the anticipated return on investment. If one business can run without the owner due to a strong management team, versus one that is highly dependent on the owner’s skills, that business will be worth more because it represents lower risk once the new owner takes over. Different buyers also impart different values to different components based on their own skills and abilities.
Also think of value in terms of “what buyers want.” They want cash flow that is dependable and predictable, i.e., lower risk. That means they want a diversified customer base, upward trends in sales and profits, good processes in place so they can replicate your success, trained employees, and a business that doesn’t rely solely on the former owner. So, it’s not just “cash flow,” but quality of cash flow. In other words, how likely (how much risk!) is it that existing cash flow will continue into the future? Lower such risk means a higher value. Higher risk means a lower value.
The most important financial number in the equation is “EBITDA”—Earnings Before Interest, Taxes, Depreciation & Amortization. You likely spent a fair amount of time with your Proforma Advisor determining the “adjusted” EBITDA for your business. This is the cash flow available to the new owner to pay themselves, service their debt, and earn a return on their investment in your business.
The buyer must take what causes your business to generate the earnings (EBITDA) and turn that into a financial number they are willing to pay that reflects the risk of owning your business going forward and achieving a suitable rate of return.
Calculating EBITDA, assuming interest and depreciation expense are 250,000 and 350,000, respectively:
If this is your income statement: | This is your EBITDA: | |||
Sales | $ 10,000,000 | Net Income | $ 900,000 | |
– COGS | $ 6,000,000 | + Interest | $ 250,000 | |
= Gross Profit | $ 4,000,000 | + Depreciation | $ 350,000 | |
= EBITDA | $1,500,000 | |||
Operating expenses | $ 3,100,000 | |||
Other items will also be added to or deducted from EBITDA, such as owner compensation, personal expenses, increased or decreased rent expense to reflect market rent (if you own real the estate), cost of any needed replacement employees after you leave, etc. So, it is really “Adjusted EBITDA” that will be assessed. | ||||
= Total Expenses | $ 3,100,000 | |||
NET Income | $ 900,000 |
A couple different methods for turning a potential financial stream into a current dollar value are called “Discounting” or “Capitalizing” earnings. It’s a way to answer the question, “what is a potential future stream of cash flow worth to me today, given the risk it entails?” For many small businesses, the capitalization of earnings rate is going to be somewhere between 25% and 33%, with outliers at 20% and 40%. For the above business, at .25 and .33, this would indicate the value as follows:
- $1,500,000 EBITDA/.25=$6,000,000
This could also be expressed as a “multiple of earnings”: 1,500,000 X 4 = $6,000,000 - $1,500,000/.33 = $4,545,000
This could also be expressed as a “multiple of earnings”: $1,500,000 X 3 = $4,500,000
That’s quite a range—$1,450,000 difference! Many factors affect where a business falls, including:
- The industry you are in. Broadly appealing? Small niche? Highly cyclical due to the economy?
- Gross margins—what is each additional $1 of revenue worth?
- Customer concentration—more risk means less value, so a higher “discount” rate.
- Dependency on the Seller—what’s the risk when you leave? Are key employees in place?
- Financial information—is your financial information clear, accurate, reliable, and up-to-date?
- The size of your business—EBITDA over $1mm, $2.5mm, $5mm and $10mm are key benchmarks for buyers. The more earnings there are, generally, the more of a premium that will be paid.
- Growth potential—remember, however, it’s the buyer who will create future growth, since they will pay you for what you did, not what they will do, but clear potential helps.
- Can a buyer realize synergies that allow them to earn more than you did on the same sales level?
- Does your business require high capital expenditures or working capital?
The above isn’t meant to imply that all small businesses are valued at “3 – 4 times EBITDA.” The median is likely around 4X with the low end around 2.5X And the upper end around 6X. Naturally, there are outliers, but financially speaking, that’s a highly inclusive range. A construction subcontractor might be 2.5-3x, depending on size, and a profitable federal contracting IT services business might be 6 X– 8X. Most will cluster in the 3.75X – 5.0X range.
Terms also make a difference. There’s a saying—you can name the price if I can name the terms. A few factors such as carrying a portion of the purchase price, keeping some ownership going forward, or structuring “earn outs” that pay you a portion of the purchase price only if the business continues to perform at a higher level can be a way to squeeze some additional value out of the business.
There is always a personal emotional element to a sale as well, though this is truer with individual buyers than experienced private equity groups or industry buyers. It’s important your business be well positioned so the buyer can envision their success in advance.
Each business’ particular circumstances will influence if they fall in the high end or low end of any given value range. A business that had EBITDA of $500k/year like clockwork for five years straight based on a diversified customer base will likely be more valuable than one that made $500k last year because of a big client or two, but only averaged $200k the prior four years, because the buyer will look at one year of earnings at $500k with skepticism as things tend to “return to the mean.” If a true shift has occurred that makes it likely the new level of profitability will continue, then that case can be made, or terms, such as an earnout as noted above, may be able to get a higher valuation while mitigating the buyer’s perceived risk.
Over time, millions of transactions in the open market have evolved and set standards for what a business is worth—what return business buyers tend to demand for the risk. Businesses attractive to “strategic” buyers may yield higher multiples because the acquisition allows them to cut duplicative costs, improve on your margins because of their market position, access certain customers, or achieve other synergistic benefits. Some industries may have more demand in a given period of time due to efforts to consolidate the industry, and some industries command higher multiples in general. And the level of earnings, as noted above, can garner higher multiples, particularly once EBITDA gets above $1 million.
Consistent, growing financial results, a diversified customer base, and a good management team are the keys to maximizing value.
By Don Beezley © 2025
Don Beezley is President of Proforma Partners, LLC and a Business Certified Appraiser (BCA) with over three decades of M&A, banking, and business operations experience.