How Private Equity Firms Evaluate Businesses Worth $5M-$25M
Businesses are often categorized into tiers by size, and those in the $5M-$25M range are considered to be in the “lower middle market” segment. This range is desirable to private equity firms because it offers undervalued opportunities, less competition from larger firms, and potential for significant returns. This means private equity firms are looking for businesses that are operationally sound and established, but still have room to grow.
With that in mind, your goal as the business owner is to understand the process of how private equity firms evaluate businesses in order to position yourself effectively for either acquisition or a partnership. This information will also be useful to avoid common pitfalls that could turn off potential buyers. Learning about and, consequently, aligning with private equity firms’ key criteria should result in the maximum valuation.
Key Objectives of Private Equity in This Range
Private equity firms place a focus on return on investment (ROI) that maximize returns within a specific time frame. Businesses in the $5M-$25M range are typically lower-risk, higher-reward since there is a proven operational stability and potential for growth. Firms will typically focus on businesses with proven profitability, an established market presence, and potential to scale.
There are a variety of deal structures that can be pursued in this range depending on the needs and goals of the business and seller. These can include:
Leveraged buy-outs (LBO) - a combination of debt and equity used to finance the acquisition
Growth Capital Investments - Minority stakes to provide the business with funds for expansion without complete ownership transfer
Add-On Acquisitions - integrating smaller companies into existing businesses
Financial Metrics PE Firms Focus On
1. Profitability: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is the gold standard for measuring operational profitability. In order to establish whether a business has efficient cost management, a EBITDA margin of 10-20% or higher is the goal. Businesses with strong free cash-flow (the amount of cash left after operating expenses and capital expenditures) enable financial flexibility for growth initiatives or leveraged buyout structures.
2. Revenue Trends: Consistency matters when it comes to revenue growth. Firms are ideally looking for a growth pattern, such as year-over-year growth of 10-20% to demonstrate a solid customer base, effective sales strategies, and demand for the business’s offerings. Diversified revenue streams are preferred to being heavily reliant on a few key clients. A recurring revenue model, such as subscription-based models, service contracts, or other recurring revenue streams, is considered to be a much more stable source of income than one-time purchases.
3. Profit Margins: The gross margin is the percentage of revenue remaining after subtracting the cost of goods sold (COGS). Higher gross margins indicate better pricing power and cost efficiency. The operating margin reflects the company’s operational efficiency by accounting for all operating expenses. The net margin (net income as a percentage of revenue) demonstrates overall profitability and the ability to generate profit after accounting for all expenses, taxes, and interest.
4. Valuation Multiples: The most common method for valuing businesses in this range is EBITDA multiples. A 5x-7x EBITDA multiple might be applied for a business with strong growth and profitability. Revenue multiples can be used for industries with high revenue but lower profitability, such as tech start-up companies. Firms could possibly use comparable company analysis (comps) which uses a benchmark against similar companies in the same industry to create a valuation multiple to ensure fair pricing.
Non-Financial Criteria Private Equity Firms Consider
1. Scalability: Firms evaluate whether the business has the systems, technology, and processes to support growth without significant additional investment. Identifying inefficiencies in production, supply chain, or distribution channels helps firms gauge the potential for improvement and cost savings. Companies leveraging modern technology tools (e.g., automation, ERP systems, or CRM platforms) demonstrate forward-thinking operations and readiness to scale.
2. Industry and Market Position: Private equity firms evaluate a company’s market share and ability to stand out from competitors. A clear competitive advantage, such as proprietary technology or a strong brand, adds value. Businesses in expanding markets with favorable trends, such as digital transformation or renewable energy, are more attractive. Stagnant or declining industries may require evidence of a niche advantage. Long-term viability is increased with high barriers to entry, like regulatory requirements, patents, or specialized knowledge, which provide insulation from new competition, increasing long-term viability.
3. Management Team: Private equity firms often look for teams with a mix of strategic insight and operational expertise. A strong middle management team ensures operational continuity and execution capability, even if senior leadership transitions. Management’s openness to working with partners, accepting guidance, and implementing strategic initiatives plays a huge factor in investment success.
4. Customer and Supplier Dynamics: A diversified customer base reduces concentration risk. No single customer should account for more than 20%-30% of total revenue. This can become over-reliance, which increases vulnerability. High retention rates demonstrate strong customer satisfaction and a quality product or service offering. This signals stable future revenue. Firms may review customer satisfaction surveys, testimonials, or Net Promoter Scores (NPS) to gauge brand loyalty and the company’s standing in the market.
Challenges and Pitfalls in Evaluating Businesses
All that being said, some common red flags that pop up when evaluating a business include declining revenue, poor financial controls, or over-reliance on key individuals. It’s important to remember to balance optimism with realism. This can help you avoid overpaying for a business in competitive markets.
If you are considering partnering with a private equity firm and your business is going to be evaluated, be sure to focus on profitability, revenue trends, profit margins, and valuation multiples. If you’d like to prepare for a private equity firm evaluation, consider enlisting the help of professionals, such as HartmannRhodes. We will happily walk your $5M-$25M business through the best route to take in order to prepare for the evaluation.
Mark Hartmann is a three-time Inc 500|5000 CEO with a rich sales, operations, and leadership background in the insurance, financial services, and healthcare sectors. With extensive experience growing and selling his own businesses, Mark leverages his expertise to help owners grow and sell businesses valued at $1M —$25M. He’s earned a Master of Business Administration from Eastern University, a master of science degree in organizational change management from St. Elizabeth University, and a graduate certificate in executive coaching from Columbia University. Mark’s professional certifications include Certified Mergers and Acquisitions Professional (CM&AP), Certified Business Intermediary (CBI), Certified Exit Planning Advisor (CEPA), and Certified Value Builder (CVB).