Valuing a business to buy is one of the most important steps you’ll take before making a purchase. Whether you want to free yourself from the corporate grind by handling a business or expand by acquiring a competitor, understanding how to evaluate a business properly prevents you from overpaying.
From analyzing seller’s discretionary earnings to assessing market conditions and business operations, knowing what to look for will help you determine if the opportunity is truly worth pursuing. This guide will walk you through business-buying considerations so you can approach your decision with confidence and clarity.
Key Takeaways
How to evaluate a business to buy: Analyze its operations and revenue by examining core offerings, customer base, and income stability. Evaluate the target market, industry positioning, and competition to assess growth potential. Assess competitive advantages and unique selling propositions to determine if the business aligns with your goals.
To assess a potential acquisition, examine financial statements, verifying records, assets, liabilities, and risks to uncover issues affecting valuation. Analyze revenue trends, profitability, and historical performance using ratio analysis. Compare against industry benchmarks, involve experts, and create a due diligence report with findings, risks, and recommendations.
Before acquiring, assess risks—operational, financial, legal, regulatory, reputational, and strategic—using SWOT analysis to identify red flags. Mitigate risks by interviewing key persons, developing a prioritized risk management plan, and leveraging due diligence insights to negotiate terms. Structure the purchase agreement with earn-outs, seller financing, warranties, and retention agreements to align incentives and reduce risks.
Understanding the Business Model
Part of how to value a business to buy is understanding how the target company operates and makes money. This can be achieved through an analysis of the company’s core offerings and revenue streams. In simple terms, how to evaluate a company for purchase means:
Figuring out exactly what products or services they sell
Who their customers are
How steady and reliable their income is
You’ll also want to take time for a thorough evaluation of the target market and industry positioning. Ask questions like: Who else is selling similar products? Is this company a leader, or are they struggling to stand out? Understanding their place in the market helps you see if there’s room to grow or if competition might make things harder.
Finally, it’s important to complete an assessment of competitive advantages and unique selling propositions. What makes this business special? Is it a loyal customer base, a standout product, or a strong brand reputation? Knowing these strengths—and any weaknesses—will give you a clearer idea if the business is a good fit for your goals.
Financial Analysis
Examining financial statements is part of how to evaluate a business to buy. This process focuses on reviewing and verifying the target company’s financial records (balance sheets, etc.), assets (both tangible and intangible assets), liabilities, and potential risks to uncover any hidden issues that might impact the company valuation or the viability of the deal.
Is the company worth acquiring? Understanding revenue trends and profitability metrics will answer this question, along with the aspects that you discover as you go through due diligence.
Financial analysis should be performed by professionals who are experts at how to determine purchase price of a business using standard formulas. Buy-side brokers will apply common valuation methods for businesses so that you can avoid undervaluing or overvaluing a company’s worth.
How to value a business for purchase can be summarized in the following steps:
Collect and review financial documents, including statements, budgets, tax returns, contracts, leases, and debt agreements.
Analyze the company’s historical and forecasted financial performance using methods like ratio and margin analysis.
Compare financial data against industry benchmarks and competitors to identify any unusual trends or discrepancies.
Conduct a site visit and meet with management to better understand operations, systems, and internal controls.
Involve external experts, such as auditors, accountants, and lawyers, to independently assess key areas.
Create a financial due diligence report highlighting key findings, risks, opportunities, and recommendations.
Due Diligence Checklist
Within the process of how to value a business to purchase is the due diligence phase. In the following sections, you’ll find lists of the aspects the buy-side needs to check.
Legal considerations and contract reviews:
List of regulatory approvals (all required and acquired)
Review of any past or ongoing violations of federal, state, or industry-specific regulatory laws and regulations
Copy of all correspondence and minutes of the meeting with the government and regulatory agencies
Commercial contracts
Their transfer provisions
Expiration and renewal dates
Notice period for termination of agreements
Restrictive covenants
Arrangements in material contracts
Operational assessment:
A complete list of all customers and clients of the company and its subsidiaries.
A list of all suppliers and third-party service providers associated with the company and its subsidiaries.
Copies of all standard purchase and supply contracts, with a summary of key terms such as pricing, conditions, rebates, and special concessions.
Copies of marketing, sales, franchise, distribution, agency, promotion, influencer, and representative agreements, plus a list of all independent salespeople or distributors.
Copies of business plans, marketing plans, sales forecasts, consultant reports, and similar materials addressing marketing strategies, pricing, off-list pricing, and industry trends, both historical and projected.
Human resources evaluation:
A schedule listing each officer, director, manager, key employee, consultant, and independent contractor, including title, tenure, and compensation details for the past three years.
Copies of employment, consultant, independent contractor, noncompetition, confidentiality, and nondisclosure agreements with all such individuals, including any amendments.
Copies of agreements or documents regarding loans or other transactions between the company (or subsidiaries) and any officers, directors, managers, employees, consultants, or contractors, along with amendments.
Copies of all employee benefit and executive compensation plans, including related documents, agreements, and amendments.
Copies of recent IRS determination letters, Form 5500s, and actuarial reports, where applicable.
Valuing a Business for Purchase
Valuations are never a straightforward process. As you discover how to evaluate a business for purchase, you’ll learn that there’s always the potential for:
Overvaluing from the seller’s side because of all the work they’ve put in
Undervaluing from the buyer’s perspective after seeing the risks from performance trends.
Achieve a balanced valuation by employing professionals who are experts in how to evaluate buying a business and industry-specific considerations when valuing a business to buy.
What can a buyer expect from a valuation? We’ve summarized the step-by-step process for valuing a company for purchase below:
Complete all financials from the past three years.
Appraisers will choose a suitable valuation method based on factors such as earnings and industry.
Computations are made from the statements and established industry multiples. Comparable analysis is performed based on businesses within the same industry.
Once the figures are presented, the buyer and seller can start with price negotiations.
Brokers and appraisers are also aware of common mistakes to avoid when determining business value. Here are some of them:
Biases based on rumors about market conditions
Comparing the target company with the wrong business
Overoptimism on the business’s growth rate and future earnings
Overlooking the role of key persons in the company
At the end of the day, an advisory team backing you up makes everything efficient.
Risk Assessment
Identifying potential red flags and liabilities should be performed before finalizing the acquisition. Risks can come from many directions—operations, finances, legal issues, regulations, reputation, and business strategy. SWOT analysis application can be used as the method to unearth internal and external risks.
If buyers don’t take the time to properly assess these risks, serious financial setbacks and lasting damage to the company’s reputation might occur.
The points below will cover some strategies for mitigating identified risks:
Interview key persons and ask questions about the risks you’ve uncovered during due diligence. Communicate clearly to establish trust and lessen uncertainties with the selling party.
Move quickly to develop a risk management plan. This plan should clearly identify the specific financial, legal, operational, or strategic risks uncovered and outline how each will be addressed. Start by categorizing the liabilities based on their potential impact and likelihood, prioritizing according to how critical they are.
Negotiation Strategies
One of the most important factors in any acquisition is how to determine if a business is worth buying at the asking price. And among the effective tactics for successful price negotiation is the use of due diligence insights.
First, you need to be aware of every element that drives the value of the business. Excellent drivers are what justifies the acquisition.
Liabilities are points of negotiation. Highlight any potential risks uncovered during due diligence, such as regulatory compliance concerns or high customer concentration. These risks can be leveraged to negotiate better terms or add contingencies that help safeguard against potential downsides.
Below are some tips for structuring the purchase agreement
Incorporate earn-out considerations and seller financing options to help bridge valuation gaps. When you structure part of the payment as an earn-out tied to the target’s future performance or offer seller financing, you can reduce upfront risk and the payment will more closely reflect the actual value delivered.
Structure payments to align incentives, ensuring that performance-based compensation ties the seller’s interests to the buyer’s goals and makes value creation a shared priority.
Secure thorough representations and warranties that allow the buyer to seek remedies if important facts are inaccurately presented. This helps protect the buyer from unexpected obligations or undisclosed risks.
Consider using retention and transition agreements to ensure key employees or the seller remain involved for a set period after the acquisition. These agreements can be essential for preserving continuity and facilitating a smooth transfer of knowledge.
FAQ
What financial metrics should I analyze to understand how to determine if a business is worth buying?
Buyers should analyze liquidity ratios, profitability ratios, and operational efficiency metrics. Additionally, the company’s debt levels should be reviewed by examining both its short-term and long-term liabilities on the balance sheet.
What is the 1% rule in business?
The 1% Rule emphasizes the importance of consistent, incremental improvement. It suggests that if a business can grow just 1% each day, that effort compounds significantly over time, leading to substantial annual growth. When evaluating a business to buy, looking for an operation that embraces steady, daily improvements could indicate strong long-term potential.
How to determine purchase price of a business using industry-specific multiples?
To determine the purchase price of a business using industry-specific multiples, research the average EBITDA multiples for that particular industry. This provides a benchmark to estimate what similar businesses are typically valued at, helping you gauge a fair purchase price.
How do you value a business with no assets?
A business doesn’t need significant assets to be valuable. Its profit or potential to generate profit is what truly matters. The basis can be the following:
Earnings
Market comparison
Cash flow
Revenue-generating intangible assets
Conclusion
Summary of key points in evaluating and valuing a business to buy:
Analyze Business Operations: Examine core offerings, customer base, and income stability to understand revenue streams.
Evaluate Market Positioning: Assess target market, industry competition, and growth potential.
Assess Competitive Advantages: Identify unique selling propositions to align with acquisition goals.
Examine Financial Statements: Verify records, assets, liabilities, and risks to determine valuation.
Analyze Financial Performance: Use ratio analysis, compare with industry benchmarks, and review revenue trends.
Conduct Due Diligence: Involve experts, create a report highlighting risks, opportunities, and recommendations.
Assess Risks: Use SWOT analysis to identify operational, financial, legal, regulatory, reputational, and strategic risks.
Mitigate Risks: Interview key persons, develop a prioritized risk management plan, and negotiate terms.
Structure Purchase Agreement: Include earn-outs, seller financing, warranties, and retention agreements to align incentives and reduce risks.
