A Business Valuation Has to Work in the Real World

When business owners think about valuation, the conversation often starts with a multiple.

If the business generates $1 million in earnings and similar businesses sell for four times earnings, the math seems pretty straightforward.

The business is worth $4 million.

Maybe.

A market multiple is an important part of a valuation, but it isn't the only thing I want to understand when looking at what a business may be worth.

I also want to know what a transaction at that price would actually look like.

Can the Business Support the Deal?

Most buyers aren't paying the entire purchase price in cash.

If a buyer is borrowing money to acquire the business, the cash flow needs to support that debt.

That means looking beyond the multiple.

How much will the buyer need to borrow?

What will the annual debt payments look like?

How much cash flow will remain after those payments?

Does the buyer still have enough to pay themselves and earn a reasonable return on the money they invested?

These questions don't determine value by themselves. But they can tell you a lot about whether a transaction at a particular price is realistic.

Not Every Dollar of Earnings Is Treated the Same

This is also where add backs become important.

A seller may calculate SDE or adjusted EBITDA by adding back expenses they believe won't continue under new ownership.

Some of those adjustments may be perfectly reasonable.

Others may be questioned by a buyer or lender.

If the earnings used to support the valuation don't hold up during due diligence or underwriting, the economics of the transaction can change quickly.

That's one reason I spend so much time looking at the quality of the earnings behind a valuation, not just the multiple being applied to them.

What Does This Mean for Sellers?

If you're thinking about selling your business, don't focus only on getting the highest possible valuation.

You want to understand how that value was determined and whether a realistic transaction can support it.

That means looking at the market, comparable transactions, earnings, risk and growth.

It also means understanding how a likely buyer may finance the acquisition and what the business looks like after the debt is taken into account.

A strong valuation should make sense on paper.

But it also has to make sense in the real world.

That's ultimately what gives you a better chance of turning a valuation into a closing.