What Is Small Business Valuation — and What Do Buyers Actually Look For?
How to value your small business, this is the process of determining what your company is worth to a potential buyer — which may differ significantly from what it’s worth to you. Buyers assess earnings (EBITDA), revenue, client concentration, key-person risk, financial record quality, and market comparables. The same business can receive very different offers depending on who the buyer is and what they’re trying to achieve.
“What’s my business worth?”
I get this question a lot. And my initial response is usually the same:
“Worth to whom?”
I don’t say that to be difficult. I say that because the answer to that question really does matter — beauty is in the eye of the beholder.
As the owner, you might have one answer to what it’s worth to you personally. But a financial buyer, a strategic acquirer, or someone backed by private equity may have very different reasons for assigning value to what you own.
Of course, there’s the textbook calculation for valuation. You can figure out your earnings, or EBITDA, and apply some kind of industry multiple. But in some industries, buyers may look at sales. SaaS companies may trade on a multiple of revenue. Different industries use different benchmarks or shortcuts.
That’s the back-of-the-napkin answer. It may even be the technically correct answer to what your business is worth. But “technically correct” and “right” are not always the same thing.
The right answer is correct plus context
Context in business valuation can be a tricky thing, because it’s difficult for any founder (even with the best of intentions) to be completely objective about your own business. And I don’t blame you — it’s your baby. You built it. You know why it’s special. You know the stories behind the customers, the products, the team, the scars, and the years of work.
But a potential buyer of your business likely sees something else.
That’s why one of the things we do with clients is give them what I call “buyer glasses.”
And then I tell them:
“Put these on and look at your business as if you were the person trying to buy it. What do you see?”
A buyer may see immense value in something you barely think about. For example, we had two female-owned consumer product businesses where the buyer added value because of the email list. One of them had $2 million added to her valuation because she sold direct to consumer and the buyer, a public company, wanted more direct access to customers.
Where she thought the email list was just how she marketed, the buyer saw a lucrative asset specific to the business goals they were trying to achieve — that’s the kind of context I’m talking about.
Of course, the reverse can also happen. You may see something as a strength because (from your perspective) it’s an essential part of how you operate. A buyer may see it as a risk.
A potential buyer will always show up with their own subjective context, which is important to understand before you attempt to sell.
Your business may be your largest investment
And it’s important to think of your business this way: as an investment. So, with that investment mindset, I want you to imagine you handed $10 million in cash to a money manager. You’d likely expect that person to grow the value of that investment. You would expect the $10 million to become $12 million or $15 million or more.
That’s how it’s supposed to work.
If you’re considering selling your company, this is the kind of the mindset you need to adopt — you are the lead investor of your business. Even if you raise capital, even if you have people on your cap table, never forget that. You had the idea. You took the risk. You are the lead investor in this bad boy.
For some of you, you may already think this way, and that’s great. For others of you, this may be new, based on how you built your business. You may have started out thinking: “I created a job for myself. I get paid for it.” I understand that, because the business does pay the bills. But it’s also the biggest asset on your financial statement. One day, it likely needs to do something for you other than give you a paycheck.
So, as your company’s lead investor, you need to understand how value gets created and how value gets lost.
Here’s an example of what I mean
About 18 months ago, a business owner called me and said he was thinking about selling. I asked him to send over some financial information, and I told him I thought he had about a $10 million company.
But I also told him there were three things that needed to change, and it would probably take 18 to 24 months to get them right:
One was client concentration. He was proud of that concentration. I told him a buyer would probably see that as something that brings down valuation.
Second, he had a lot of key-person risk. He was at the center of almost every process in the business. He saw that as quality control. A buyer sees that and thinks, “That is a risk.”
Three, his accounting methods needed work. He was using cash accounting, which may get you tax compliant and get the IRS out of your hair. But the private equity folks are going to recast those numbers. They’re going to know more about the financial workings of your business than you’ve ever cared to know, and they’re going to use that knowledge in the deal.
He didn’t hire us at the time and disappeared.
Then he called about a month ago. He had a letter of intent from a buyer. The valuation was $7 million: $3 million in cash and $4 million in earnout.
He wanted me to get him to $10 million. I told him, I’m sorry, I can’t do that now. You already have a deal.
Later, we were on a call with the buyer, and I asked what they would be paying if the financials had been recast and presented the way they had done it. The answer was probably $12 million.
One change took $5 million off the value of his business.
That is the part I hate like a snake.
You’re exceptionally good at what you do
Many of you are likely unbelievable subject matter experts, team leaders, operators, creators, product people, and marketers. That’s why you have a business you believe that is genuinely worth something.
You are excellent at the game of your business. But valuation is an entirely different game, and buyers may know that game better than you do.
I share this with you because it can become a blindspot that puts you at an extreme informational disadvantage. And the last thing I want you to do with your business, your baby, is to take a water gun to a knife fight.
Here’s where I’d tell you to start
If you’re wondering what your business is worth, here are the questions I would start with:
First, how fast can you produce a monthly P&L and balance sheet for the last 24 months? Is that two mouse clicks away? Or is it eight weeks of pulling your hair out? That will tell me a lot. If that question sends you into a spiral, valuation may not be the first place to start. Instead, I’d direct you to focus on bookkeeping before anything else.
Bookkeeping is the foundation for valuation. You have to be able to prove mathematically what the business is doing and demonstrate it in good order to an outsider. To a buyer, messy records can look like a shoebox of problems. They may still move forward, but they’re going to discount for the uncertainty.
Second, who is the likely buyer for your business? Has anyone ever expressed interest in a real way? What were they like? What questions did they ask? What made them pause? A lot of your market research may already be sitting in the questions interested parties have asked you.
Pay attention to that. Again, beauty is always in the eye of the buyer.
Third, are you showing profit and paying taxes? Or is your CPA practicing the dark arts at year-end to zero everything out? To be clear, I understand why people do it. Nobody is excited to pay more tax than they have to. But if the goal is eventual valuation, zeroing everything out can create a different problem.
There are no laws against running a lifestyle business
For some of you, a lifestyle business may be the entire point. But if you want the business to sell someday, the valuation math gets harder when the business cannot show profit, reinvestment, or clean financial performance.
At the same time, loads of free cash flow can signal something else to a sophisticated buyer: this business may be underinvested. If they believe they can add people, systems, or capacity while maintaining margin, they may see opportunity you have not acted on.
Start by asking the right questions
If you’re considering selling your business, make it a point to have high-quality bookkeeping. When you do that, it will give you the information you need to make informed, objective decisions in your business, rather than simply being a mechanism to help you file your taxes.
As a business owner, it becomes all too easy to live in the urgent and spend very little time in the important. I get it, I really do. There’s always something on fire, someone always needs something, something is always shifting in a way you didn’t expect.
But if you adopt the identity of lead investor in your business, you start asking different questions:
- What would I expect from this investment?
- What would I need to know?
- What would I fix now, before a buyer defines the value for me later?
You have built something valuable, and I congratulate you for that. Start chipping away at those things. Hire an adviser if you need help.
Now you need the financial visibility to defend and grow that value before someone else decides what it’s worth for you.
