Non-startup private businesses are bought for many reasons — from purely financial returns to synergies with existing companies, or even personal lifestyle reasons.
And although buyers come from diverse backgrounds with varying reasons for buying a business, they have one thing in common: they have to calculate a valuation for your company as part of their due diligence.
In this article, we’ll explain who business buyers are and common frameworks for valuing a non-startup business.
Wait—what defines a “non-startup” business?
Categorizing a private business as a “startup” or “non-startup” can be quite subjective. The distinction is most often used for marketing purposes — like inclusion in certain publications, pitching to VCs, or investors defining the companies they invest in — rather than for any official means.
Although different investors may give you somewhat different answers, the general characteristics of a non-startup business are:
- Focus on fundamentals. Profitability and healthy unit economics are defining characteristics of non-startup businesses. This can enable organic and efficient growth.
- Little or no high-growth capital. Non-startup businesses may take on outside capital from time to time, but multiple rounds of VC financing are not common. At the same time, VCs don’t typically invest in non-startup businesses because they require investments to have a much higher return potential to make up for their losses — a concept broadly described as the power law principle.
- Value created from earnings. Non-startup businesses are generally valued on earnings (put simply profit, or revenue minus expenses) rather than revenue (aka all the money coming in) because acquirers are purchasing cash flow, unlike those who invest based on the promise of strong future growth.
Examples of non-startup businesses might include a pool cleaning company that services local homeowners, a small group of dental practices, or a digital marketing agency.
Types of non-startup business buyers
There can be many reasons why a firm or individual would want to buy a business — and a buyer’s particular motivation can influence how they value particular aspects of a business. This is why business buyers are categorized by their intent for the acquisition. Here are a few examples:
Financial buyers
Financial buyers — as the name suggests — buy private companies primarily for financial returns. Groups in this category are investment firms, like private equity firms and family offices. Typically these buyers rigorously analyze a company’s financial statements and prioritize the return on investment they could earn. It’s common for financial buyers to use debt to finance part of the acquisition to maximize their return on invested cash.
Strategic buyers
Strategic buyers are generally companies that are interested in integrating another company’s services into its own or acquiring a smaller, competing company. These purchases can allow the acquiring company to better serve its existing customer base, expand into new markets, or reclaim a larger market share. Strategic buyers will typically consider ways that the two companies can complement each other and the impact on their financials as core drivers of their valuation.
Individual buyers
Individual buyers buy businesses in their area of expertise either for lifestyle reasons or a financial return. These buyers are usually owner-operators who either run the business themselves or put in place a management team to run the day-to-day operations.
Valuation methods for non-startup acquisitions
Depending on an acquirer’s intent or goals in buying a business, the valuation methods used in their due diligence can vary. In general, acquirers use three types of valuation models for analyzing a non-startup business for acquisition: an income approach, a market approach, or an asset approach.
Let’s take a closer look at these valuation methods.
Income approach
The income approach states that the value of a business is the present value of expected future cash flows. In order to value a company using the income approach, investors will need to create a discounted cash flow (DCF) model.
In general, the steps of creating a DCF model are:
- Forecast the company’s future free cash flow, as well as the company’s “terminal value” — the estimated value of the company beyond the initial forecast period in the model.
- Discount the future cash flows using the investor’s required rate of return.
- Add the net value of any non-operating assets the company has on hand, like cash, to the present value calculation of expected future cash flows.
This valuation methodology is one of the core financial models that financial buyers create when analyzing an investment opportunity. Ultimately, an acquirer wants to answer the question, “What is the value today of the economic benefits I will be entitled to in the future if I buy this company?”
Market approach
The market approach determines a valuation by comparing the target company’s financial performance to the performance metrics and relative valuations of similar companies in the market.
In this approach, buyers will generally try to find comparison companies that are as close as possible to the target company for which this valuation is being done. Importantly, no two companies will be identical — so it’s critical that this model includes adjustments based on the unique differences between the comps and the target company. There are two types of comparisons that can be made under the market approach.
Public companies: Publicly traded companies have a significant amount of financial information available, making them ideal data points for analyzing comps in a potential acquisition.
- Finding relevant comps: An acquirer can filter companies by industry, customer base, technology, or other factors that draw meaningful parallels between the two companies.
- Comparing valuation multiples: Using publicly available information, an acquirer can analyze the valuation — either enterprise value or market capitalization — of the company relative to core financial metrics. Common metrics that are used include sales, operating income, and earnings. This multiple can then be applied to the target company to determine the valuation.
Precedent transactions: Similar to publicly traded comparisons, acquirers can analyze the data from past mergers and acquisitions (M&A) to find the performance metrics and valuation multiple those companies “traded” at. These comps can highlight the multiples that private companies are being sold for, giving investors a realistic snapshot of what they could expect to pay, before factoring in any valuation adjustments.
“Buyers commonly determine a business's value by analyzing its historical earnings,” says Matthias Smith, CEO of Pioneer Capital Advisory LLC. “They adjust these earnings based on factors that represent normalized operations and then apply an industry-specific multiple. For instance, if you're purchasing a business with a market multiple of 4x EBITDA, and the EBITDA for the most recent year is $1 million — which you believe reflects future earnings post-purchase — the business would be valued at $4 million (4 times the $1 million EBITDA).”
Asset approach
The asset approach is a valuation method that estimates the market value of a company’s total assets minus the company’s liabilities. This is the value of a company if all of its assets were sold off on the open market and liabilities were paid. Notably, this isn’t the same as a company’s “book” value, which values its assets and liabilities using accounting standards, rather than the market value.
Since this approach doesn’t consider the company’s ability to generate future earnings, it’s less commonly used by financial buyers. Instead, this valuation method is often used in the event of a business undergoing liquidation or an immediate fire sale.
Accounting adjustments in valuation analysis
A company’s financial statements don’t always reflect the true economic value of a business. When an acquirer analyzes a potential investment opportunity, they need to “normalize” the financial statements — i.e., add and subtract line items to better reflect what the economic value will be like if the acquirer buys it. Examples of common line items that might need to be addressed during this process are:
- Owner salary and benefits
- Discretionary expenses (e.g., travel or marketing)
- Non-recurring income or expenses (e.g., restructuring costs)
- Labor expenses
- Forgiven accounts receivables
- Rent for (e.g.,) office or warehouse space
These kinds of line items commonly get adjusted up or down because their value under existing ownership is different than what they might be under new ownership.
For example, the seller of a company may be significantly overworking themselves, doing the jobs of what three employees would typically do.
If the new owner expects to hire employees for these roles — instead of working all the hours themselves — then these new labor expenses would lower the company’s future earnings, all else being equal.
This is also an example of how valuation can have slight nuances depending on the investor who is analyzing a deal. There’s grey area that isn’t as straightforward as building a simple forecasting model.
Non-startup businesses can be attractive investment opportunities. When it comes to valuation, the way that an acquirer underwrites a business is different than how VCs calculate the value of a startup. Whether the acquisition is because of strong earnings, synergies with existing products, or a lifestyle hobby, valuation is a key aspect of due diligence for investors who are interested in purchasing your company.
Tucker McKay