Business Valuation Explained: How Buyers Actually Price Companies
Business valuation is often presented as a technical exercise: apply the right formula, input the correct numbers, and a definitive value emerges. The reality is more nuanced. Valuation is part science and part judgment, informed by methodological frameworks but ultimately driven by how buyers perceive risk, opportunity, and strategic fit.
Understanding how buyers actually price companies helps founders prepare for transactions and set realistic expectations. The process involves multiple methods, each with strengths and limitations, synthesised through judgment that no formula can replicate.
The Fundamental Question
Every valuation answers the same fundamental question: what is a buyer willing to pay today for the right to receive this business's future cash flows? The answer depends on how much cash the business is expected to generate, how confident the buyer is in those projections, and what alternatives the buyer has for deploying capital.
Different buyers answer this question differently. A strategic acquirer modelling synergies may reach different conclusions than a financial sponsor modelling standalone returns. Both may be correct given their distinct circumstances. Valuation is not about finding a single true number but understanding the range of values that different buyers might reasonably assign.
The Three Primary Valuation Methods
Professional valuation practice relies on three primary approaches, each providing different perspective on business value.
Income Approach: Discounted Cash Flow
The income approach values businesses based on expected future cash flows, discounted to present value. The logic is straightforward: a business is worth the present value of the cash it will generate over time.
The standard discounted cash flow methodology involves projecting free cash flows for a forecast period, typically five to ten years, then estimating a terminal value representing cash flows beyond the forecast period. These future amounts are discounted at a rate reflecting the risk of achieving them.
The formula is elegant:
Enterprise Value = Sum of (FCF / (1 + r)^t) + Terminal Value / (1 + r)^n
Where FCF is free cash flow, r is the discount rate, t is the year, and n is the final forecast year.
DCF analysis is theoretically rigorous but practically challenging. Small changes in assumptions produce large changes in output. A business projected to grow at 15% versus 10% annually, or discounted at 12% versus 15%, will show dramatically different values. The method requires judgment about future performance that cannot be mechanically derived.
For lower middle market transactions, DCF analysis often serves as a sanity check rather than primary valuation method. The projection and discount rate assumptions that drive the model are difficult to defend for smaller businesses with shorter operating histories and less predictable cash flows.
Market Approach: Comparable Analysis
The market approach values businesses by reference to what similar businesses have sold for or currently trade at. The logic mirrors residential property valuation: your house is worth roughly what similar houses in your neighbourhood have sold for recently.
Two variants of market approach are common in practice.
Precedent transactions analysis examines completed acquisitions of similar businesses. If comparable companies have sold for 5x to 7x EBITDA, your business might be worth something in that range, adjusted for differences in size, growth, profitability, and risk.
Comparable company analysis examines public company trading multiples. If publicly traded companies in your industry trade at 10x EBITDA, your business might trade at a discount to that figure, reflecting the illiquidity and scale differences between public and private companies.
The market approach is intuitive and grounded in actual transactions, but requires genuinely comparable businesses. Finding true comparables for lower middle market companies is often difficult. Public companies are typically much larger. Private transaction data is scarce and often incomplete. The adjustments required to account for differences can overwhelm the signal from the comparables themselves.
Asset Approach: Adjusted Net Assets
The asset approach values businesses based on their underlying assets, adjusted from book value to fair market value. The method asks: what would it cost to assemble these assets independently?
For most operating businesses, particularly technology and services companies, the asset approach produces valuations well below what the business would actually sell for. The value of a going concern typically exceeds the value of its separable assets because operating businesses generate returns that idle assets cannot.
The asset approach has applications for asset-intensive businesses, real estate holding companies, and liquidation scenarios. For typical lower middle market acquisitions, it serves as a floor value rather than a primary methodology.
How Buyers Apply These Methods
Sophisticated buyers do not simply pick one method and apply it mechanically. They use multiple methods, weight them based on circumstances, and apply judgment informed by transaction experience.
Primary and Secondary Methods
For most lower middle market transactions, buyers rely primarily on market multiples, specifically earnings multiples derived from comparable transactions. This approach is practical: it reflects what buyers have actually paid for similar businesses, which is the most relevant indication of what they might pay for yours.
DCF analysis typically serves as a secondary check. If the multiple-based valuation implies a DCF value at unreasonable discount rates, something in the analysis requires examination. The methods should produce broadly consistent results; significant divergence signals that assumptions somewhere need scrutiny.
The Multiple Framework
In practice, most lower middle market transactions use earnings multiples as the primary valuation framework. Enterprise value equals some measure of earnings multiplied by some multiple:
Enterprise Value = EBITDA x Multiple
Or for SaaS and subscription businesses:
Enterprise Value = ARR x Multiple
The multiple itself is not arbitrary. It reflects the buyer's assessment of business quality, risk, and growth potential. SaaS Capital's 2025 research shows private SaaS companies trading anywhere from below 1x to above 20x ARR, with the median around 5x. The variation reflects fundamental differences in business characteristics that buyers recognise and price.
What Drives the Multiple
Buyers adjust multiples based on specific business characteristics. The factors that most significantly affect where a business falls within the range include:
Growth rate: Faster-growing businesses command higher multiples because buyers are purchasing future cash flows, not just current performance. The relationship is non-linear: each incremental percentage point of growth above 30% has larger valuation impact than growth in slower businesses.
Retention and revenue quality: McKinsey's research found that companies in the top quartile of net revenue retention achieved valuation multiples significantly higher than lower-retention peers. Revenue that recurs reliably is worth more than revenue that must be constantly replaced.
Profitability and efficiency: The Rule of 40, combining growth rate and EBITDA margin, has become a standard efficiency metric. McKinsey's analysis shows that top-quartile performers on this metric generate nearly three times the valuation multiples of bottom-quartile companies.
Risk factors: Customer concentration, owner dependency, competitive threats, and operational fragility all reduce multiples. Buyers discount for uncertainty, and every risk factor represents uncertainty about whether projected performance will materialise.
The Normalisation Process
Before applying any valuation method, buyers normalise the earnings figure they are valuing. Reported financials rarely reflect the economic reality that matters for valuation purposes.
Owner Compensation Adjustments
Owner-operated businesses often show compensation significantly above or below market rates. A founder paying themselves $400,000 when market compensation for a CEO would be $200,000 has understated true profitability. Conversely, a founder paying themselves $100,000 while working 70-hour weeks has overstated it.
Buyers adjust reported earnings to reflect market-rate compensation for the roles the owner performs. This normalised figure represents what the business would earn under typical ownership, which is what the buyer is actually acquiring.
Non-Recurring Items
One-time expenses and revenues distort operating performance. Legal settlements, pandemic-related disruptions, facility relocations, and non-recurring customer projects all affect reported figures without reflecting ongoing economics.
Buyers identify and adjust for these items, attempting to isolate the recurring earnings power that will persist after acquisition. The adjustments are often contentious: sellers want to add back expenses, while buyers want to ensure they are not paying for one-time gains.
Related Party Transactions
Businesses often transact with related parties at non-market rates. Rent paid to a property owned by the founder, services purchased from family members, or products sold to affiliated businesses may not reflect arm's length pricing.
Buyers adjust these transactions to market rates. If you pay $2,000 monthly rent for space worth $4,000, buyers add $24,000 annually to expenses. If you receive below-market services from related parties, buyers add the market cost. The goal is financials that reflect economic reality.
How Strategic and Financial Buyers Differ
Different buyer types approach valuation with different frameworks and priorities.
Strategic Buyers: Synergy Value
Strategic buyers acquire businesses that fit within their existing operations. They can often pay premium prices because they can extract value beyond standalone performance.
Revenue synergies arise when the acquired business can sell to the acquirer's customer base, or vice versa. Cost synergies arise when overhead can be eliminated or operations consolidated. Technology synergies arise when the acquired capabilities accelerate the acquirer's roadmap.
Strategic buyers value these synergies and may share some of that value with sellers through higher purchase prices. The same business might be worth 4x EBITDA to a financial buyer and 6x to a strategic buyer who can realise substantial synergies.
Financial Sponsors: Return Requirements
Private equity buyers model returns explicitly. They calculate what combination of entry multiple, growth trajectory, leverage, and exit multiple produces their target internal rate of return, typically 20% to 25% or higher.
Bain's research on private equity investing confirms that financial sponsors focus intensely on operational value creation. The days of financial engineering and multiple expansion alone are over. Today's successful private equity investors must demonstrate genuine operational improvement to achieve target returns.
This focus on operational improvement means financial buyers examine businesses carefully for improvement opportunity. Businesses with clear paths to margin expansion, growth acceleration, or operational efficiency attract premium interest.
The Process That Determines Price
Valuation analysis establishes reference points, but actual transaction prices result from market processes involving competition, negotiation, and deal structure.
The Power of Competition
The most significant factor in achieving premium valuations is buyer competition. A well-run process generating interest from multiple qualified buyers creates competitive tension that drives prices upward. Limited buyer engagement may produce results below what fundamentals suggest.
Competitive processes do not simply produce higher prices; they also improve terms. Buyers competing for a deal offer better structures, more favourable representations and warranties, and faster closes. The benefits of competition compound across multiple transaction dimensions.
Information Quality
Buyers pay more for certainty. Clean financials, complete documentation, verified metrics, and organised data rooms all signal operational quality and reduce perceived risk. Businesses that present poorly face discounts even when underlying performance is strong.
PwC's analysis of technology transactions emphasises that well-prepared sellers achieve better outcomes. The effort invested in preparation pays returns through higher valuations, smoother processes, and better terms.
Deal Structure Matters
Headline valuation is not the only consideration. Deal structure affects the true economics of a transaction. Earnouts, seller financing, employment agreements, and working capital adjustments all influence what the seller actually receives.
A $10 million offer with 40% in earnouts tied to aggressive targets differs fundamentally from an $8 million offer with full cash at close. Evaluating offers requires looking beyond headline figures to the complete structure and associated risks.
Preparing for Valuation Discussions
Founders approaching transactions can take specific steps to improve valuation outcomes.
Know Your Numbers
Before engaging with buyers, understand your business through their lens. What is your normalised EBITDA after appropriate adjustments? What are your retention metrics, growth rates, and efficiency measures? How do you compare to comparable businesses that have transacted?
Buyers will perform this analysis regardless. Founders who understand it beforehand can position their businesses more effectively and negotiate from knowledge rather than uncertainty.
Address Weaknesses Proactively
Every business has characteristics that reduce value: customer concentration, owner dependency, operational inefficiencies, or documentation gaps. Addressing these before a transaction improves both valuation and process efficiency.
Some issues cannot be fixed quickly. Customer concentration built over years does not disappear in months. But demonstrating awareness of issues, having plans to address them, and showing progress all affect how buyers perceive and price risk.
Prepare Documentation
Buyers request extensive documentation during due diligence. Having clean, organised materials ready accelerates processes and signals operational quality. Poor documentation creates delays, raises questions, and often leads to valuation adjustments.
Standard requests include: financial statements and tax returns for three to five years; detailed revenue breakdowns by customer, product, and period; customer contracts and renewal history; employee information and compensation details; and operational documentation covering key processes and systems.
Understand Your Buyer Universe
Different buyers value different characteristics. Strategic buyers may pay premiums for specific capabilities or customer relationships. Financial sponsors may value operational improvement opportunities. Understanding who might want your business, and why, helps position for optimal outcomes.
The Reality of Valuation
Business valuation combines analytical methods with market processes and human judgment. The methods provide structure; the market provides price discovery; judgment bridges the gap between theoretical frameworks and practical reality.
Founders who understand how buyers actually price companies can navigate transactions more effectively. They can prepare businesses to present well, engage in valuation discussions knowledgeably, and evaluate offers against realistic benchmarks.
The goal is not to find a single true value but to understand the range of values that reasonable buyers might assign and to position for outcomes at the upper end of that range. That positioning involves business quality, preparation quality, and process quality, all informed by understanding how valuation actually works.
If you are considering a transaction and want to discuss how buyers might value your business, we would welcome the conversation.