Most people I talk to think the price of a business is based on a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). That’s part of it for sure but it’s really where the story ends and not where it begins.

Here’s how it really works:

Buyers want to buy companies whose earnings will grow in the future. That’s what they’re almost always looking for. How they figure out which companies they think will grow and which they pass on is the magic, the charm and the challenge of the mergers and acquisitions process.

Every company has a story, not just how it began or the challenges it overcame but who it is now.

For brands and retailers, that story covers consumers, company economics, growth potential and management. For example:

• Are consumers making repeat purchases? How loyal are they? Do they recommend the company to friends in person or on social media? Does demand fall if prices increase even slightly? Do consumers identify with the brand’s values on issues that matter to them?
• Can the company communicate directly with its consumers, or must it continually pay social-media platforms and other intermediaries to reach them?
• Does the company have dependable margins, or have they been erratic? Are adjustments for owner-related and other private-company expenses credible? Is the inventory clean?
• Can a credible case be made that the business can grow through additional stores, products or channels without requiring a disproportionate investment? Has that potential been tested and demonstrated?
• Can the business succeed without its founder or current leader? Is there sufficient management depth to run and grow the company under new ownership?
• For a retailer, are individual stores profitable? How much does a new store cost and how quickly is the investment recovered? Do new locations perform like the original ones? Are there opportunities for geographic expansion? Do most of the stores improve every year? Are lease costs reasonable?

The right answers to those questions help explain why a company has performed well and whether that performance is likely to continue. That greater confidence can cause buyers to stretch to a higher multiple of EBITDA to win the deal.

We have seen two businesses with roughly comparable revenue and EBITDA attract dramatically different reactions from buyers. One had repeat customers, clean inventory and a functioning management team; the other depended on a single customer, one hero product and its founder. Buyers viewed the latter company’s earnings as riskier, less certain and therefore less valuable.

Value is created when management can show why customers buy, why they come back, why the margin is defensible and why those conditions can survive a change of ownership.

Numbers alone are not the story of a company. Giving a buyer the understanding of why consumers act the way they do towards the company gives them a way to see how good performance can continue. Connecting a complex story of “why” to the numbers is how value is developed.

Of course, it matters who the buyer is. But it’s backwards to decide, before a sale process begins, which buyer will value the company most highly.

Just as it’s difficult to predict whether two people will develop romantic sparks when they meet, it’s difficult to know in advance which buyer will see exceptional value in a particular company. A good sale process includes the obvious buyers but also searches for outliers whose strategy, capabilities or circumstances lead them to value the opportunity more highly.

The way to attract those outliers is to tell a compelling story supported by evidence. The parties that find that story most compelling are likely to pay the highest price whether they were obvious candidates or not.

Where Problems Creep In

Inventory is where many attractive stories begin to come apart. In consumer businesses, inventory can be an asset, a warning or both. Buyers will ask how much is current, how much is seasonal, how much is committed to customers and how much is being held because management is unwilling to recognize that some products can’t be sold. Buyers will examine inventory in excruciating detail for slow-moving products, returns, chargebacks, obsolete packaging, in their hunt for postponed write-downs.

Unrealistic inventory values may improve earnings or reduce taxes for a moment in time. But diligence will likely expose it and once found, can reduce value, damage credibility or derail a transaction.

A quality-of-earnings review tests the same issue more broadly. Buyers do not accept EBITDA and adjustments just because they appear in a spreadsheet. They ask whether revenue was recognized consistently, whether gross margin includes all freight and fulfillment costs, whether owner expenses are genuinely nonrecurring and whether working capital has been managed normally. They examine customer concentration, promotional spending, returns, vendor terms and the cash required to support growth.

The objective is not to eliminate every adjustment. Founder-owned companies often have legitimate expenses that will not continue after a transaction. The objective is to make each adjustment credible, documented and consistent with the operating story. An adjustment supported by documents and records and a clear post-closing plan can survive scrutiny.

Buyers also pay for the quality of revenue. Recurring or contractual revenue can be valuable, but only if the underlying customer behavior is healthy. Wholesale revenue from a large retailer can be attractive, but not if one retail customer can erase the company’s profit with a reset. Direct-to-consumer revenue can provide customer data and margin, but not if customer acquisition costs rise faster than the gross profit from those sales.

Management depth matters for the same reason. A founder may be the source of the company’s creativity and relationships, but a buyer needs to know who runs merchandising, finance, operations, sales and supply chain after closing. A business that cannot function without its founder is not unsaleable, but the buyer will price in the transition risk and could require a longer earnout or employment period or a bigger rollover.

For founders, the practical lesson is to prepare before approaching buyers. Clean financial reporting, a defensible margin bridge, customer and cohort analysis, current inventory data, management depth, protected intellectual property and realistic objectives do more to create competition for an acquisition than a long list of theoretical acquirors.

A well-run sale process doesn’t ask a buyer to believe a story that can’t be proved. It shows how the story supports the metrics and why consumers will continue to reward the company with loyalty that enables good financial performance.

We often express the value of a company as a multiple of EBITDA. But that multiple is derived from a deep and thorough examination of a business’ uniqueness and the relationship it has with its ultimate consumers. When consumers show through their behavior that they value what a company is selling, buyers can value the business based on what it is capable of earning in the future, not just on what it earned in the past.