One of the most important questions when buying a business is also one of the hardest to answer:
What is it actually worth?
The seller may have an asking price, but that doesn’t necessarily mean the business is worth that amount to you.
As a buyer, valuation is about understanding the earnings you’re acquiring, the risks attached to those earnings and what return you could reasonably expect from your investment.
Start with the underlying earnings
For many established profitable businesses, valuation starts with EBITDA.
EBITDA broadly represents earnings before interest, tax, depreciation and amortisation and is commonly used to compare the operating profitability of businesses.
A simple valuation might look like:
Maintainable EBITDA × Valuation Multiple = Enterprise Value
For example:
£800,000 EBITDA × 5x = £4 million enterprise value
The calculation itself is straightforward.
The more difficult questions are whether £800,000 represents the true maintainable earnings of the business and whether 5x is the right multiple.
Don’t automatically accept the seller’s EBITDA
The EBITDA presented in sale materials will often include adjustments.
Some will be entirely reasonable.
For example, the seller may have incurred a £75,000 one-off legal cost that won’t continue under new ownership. Adding this back could give you a more accurate picture of future earnings.
But adjustments need to work both ways.
Suppose the owner currently manages the business and takes a relatively small salary. If you need to recruit a managing director on £120,000 after completion, that cost needs to be reflected in your assessment of maintainable earnings.
Your job is not to arrive at the highest possible adjusted EBITDA.
It is to work out what the business is realistically capable of earning under your ownership.
How do you decide what multiple to pay?
There isn’t a universal EBITDA multiple that applies to every business.
The multiple reflects how buyers perceive the quality, risk and future prospects of those earnings.
A business may justify a higher valuation where it has characteristics such as:
- consistent growth
- recurring or contracted revenue
- strong margins
- low customer concentration
- a capable management team
- limited reliance on the owner
- a defensible market position
- good cash generation
The opposite can reduce what a buyer is willing to pay.
This is why two companies generating the same EBITDA can have very different valuations.
Look at what you’re buying
Historic financial performance matters, but you are not buying last year’s profit.
You are buying the right to the future cash flows of the business.
Try to understand what makes those earnings sustainable.
How secure are the customers?
Are contracts likely to renew?
Is the market growing or declining?
Could a competitor easily replicate what the company does?
Are margins sustainable?
Does the business require significant capital expenditure?
If earnings look attractive today but there is a significant risk they decline after the acquisition, that should be reflected in your valuation.
Be careful with growth forecasts
Sellers will naturally want buyers to understand the future potential of their business.
Forecasts can be useful, particularly where there is strong evidence behind them.
But you should distinguish between growth that is already visible and growth that still needs to be created.
A signed customer contract beginning next year is very different from a forecast based on entering three new markets that the company has never operated in before.
You should be cautious about paying today for growth that you will have to deliver yourself.
Understand enterprise value and equity value
This distinction matters when discussing price.
An EBITDA multiple will usually produce an enterprise value, which represents the value of the underlying operations.
The amount ultimately paid for the shares may then be adjusted for cash, debt and other agreed items.
In simplified terms:
Enterprise Value + Cash – Debt = Equity Value
Working capital and other completion adjustments may also affect the final consideration.
Make sure everyone is clear about what an agreed valuation actually refers to.
Consider the deal structure as well as the price
The headline valuation isn’t the only thing that determines whether an acquisition is attractive.
Consider two offers for the same business:
Option A: £4 million paid entirely on completion.
Option B: £4.5 million, with £3.5 million paid on completion and £1 million dependent on future performance.
The second has a higher headline price, but the buyer is taking less risk upfront.
Deferred consideration, earn-outs and vendor finance can sometimes help bridge a valuation gap between buyer and seller.
They should not be used to make a bad acquisition look affordable, but transaction structure can be an important part of managing risk.
Work backwards from your expected return
Valuation shouldn’t only be based on what similar businesses have sold for.
Think about what the acquisition looks like from your own perspective.
How much equity will you need to invest?
How much debt will the business carry?
What cash could the company generate after debt repayments, tax and investment?
What could the business realistically be worth in five years?
There is a big difference between being able to fund an acquisition and being able to generate an attractive return from it.
Don’t let the asking price anchor your thinking
If a business is marketed for £5 million, it is very easy to start your analysis around £5 million.
Try to form your own view first.
Understand the earnings, risks, market and future potential and then decide what you believe the business is worth.
You can compare that figure with the seller’s expectations afterwards.
Sometimes the two will be close. Sometimes they won’t.
What should you pay for a business?
There is no single correct answer.
The right price needs to reflect the quality of the business, the sustainability of its earnings, the risks you’re taking and the return you expect to make.
A good business can still be a poor acquisition if you pay too much for it.
Equally, the cheapest business isn’t necessarily the best investment.
The objective is not simply to negotiate the lowest possible price.
It is to understand what you’re buying and pay a price that makes sense for the opportunity and the risk involved.
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