Some people are saying that 2005 will be a big year for acquisitions, and -- judging by the businesses I'm in -- I don't doubt it. Document destruction companies have been getting snapped up lately, and the market for records storage businesses has been hot as well. In an environment like this, it's only natural that many business owners would be looking for opportunities to cash out. Unfortunately, most of them have grossly inflated notions of what their companies are worth.

Inc. 500 companies are prime examples. I recently looked at Inc. 500 applications from about 20 of the companies on the current list. One had lost money on sales of about $60 million, and yet its owners thought it was worth between $50 million and $100 million. Evidently they hadn't heard what happened to all those profitless Internet companies of the 1990s. Another company had a net profit of less than $335,000 on sales of about $6.5 million -- and still the owners somehow came to believe it was worth between $100 million and $200 million. In fact, of the 20 companies, I'd say that about half reported absurdly high valuations. Most of the others were just extremely high.

It's easy to understand how Inc. 500 CEOs, and former Inc. 500 CEOs, get such ideas. As a group, after all, we tend to have fairly large egos, which isn't entirely bad. You need one to make a business grow fast enough to make the list. But our egos can get us in trouble when it comes to putting a dollar value on something we've created. We generally take the highest valuation we've heard for a company somewhat like ours -- and multiply it.

Most owners have inflated notions of what their companies are worth.

But it's not just the fast growers who think their companies are worth more than they really are. Consider a deal that was brought to my attention a few months ago by my partners in the document destruction business, Bob and Trace Feinstein. They'd heard about a smaller company that was looking to be acquired. The owner was asking for two times annual sales, or about $1.2 million. Since other document destruction companies had been selling for three times sales, Bob and Trace thought we ought to buy it. But they were making a common mistake.

You can't value a company simply by looking at its sales. Yes, every industry has a rule of thumb for doing valuations and usually it's expressed as a multiple of sales, but that's a matter of habit and convenience. What most buyers are interested in is something called free cash flow, and free cash flow is a function of profit, not sales.

As it turned out, the company Bob and Trace were talking about had very little profit at all. It consisted of a father and son who had a truck with a shredder on it. All they cared about was earning a living, which they could accomplish by doing massive amounts of shredding at an extremely low price -- six cents per pound. They probably did all right for themselves, but the business had no value to a company like ours.

To begin with, it would cost us more than six cents a pound just to collect the paper and make sure the shredding was done in a secure manner -- forget about any contribution to overhead. Of course, the father and son weren't worried about overhead: They didn't have any. They had no significant expenses above and beyond the cost of actually providing the service. As a result, they could get by without producing gross profit. But no business that does have overhead can survive without gross profit. It's the gross profit that covers the overhead expenses and provides the net profit you need to build the company and get a return on your investment. We would never consider buying a business without gross profit. We wouldn't even buy the father and son's customer list. Once we started charging realistic prices, the chances of our holding on to the customers would have been zero to none.

So how, you might ask, did the father and son get the notion that their business was worth $1.2 million? The same way most people do. When you hear that a company in your industry has sold for three times sales (or whatever), you naturally figure that your company must be worth something in that range, just as you're likely to think your house is worth approximately what the one down the street just sold for -- even though you know nothing about what's in that house or why the buyer wanted it.

I cured myself of this tendency by talking to people interested in buying my company, and I'd recommend that you do the same. You need to begin by understanding what buyers are looking for, which depends on who the buyers are. Some companies do acquisitions for strate- gic reasons, some because they want to gain market share, some because they see a potential for synergy, and some because they want to boost their bottom line. Whatever may be driving them, however, it's a safe bet that they will look first at your earnings before interest, taxes, depreciation, and amortization, or EBITDA. When you subtract from that number the minimum amount of new capital expenditures required each year (or CAPEX), you get a pretty good measure of free cash flow. That is, you see the amount of cash a company generates in a year after paying all of its operating costs and expenses and meeting its minimum new capital requirements but before covering what it owes in taxes and interest (which the acquirer might not have to pay) and before deducting depreciation and amortization (which are accounting mechanisms reflecting the cost and lifespan of certain assets).

Assuming acquirers can determine your company's EBITDA, other factors then come into play. I say "assuming" because most small companies don't have audited financials and don't keep financial records well enough to make a reasonable guess at EBITDA. Without that information, you probably won't be able to sell your business to a sophisticated acquirer, and you certainly won't get top dollar for it.

Let's suppose, however, that your company has nice, solid EBITDA and you can prove it. You're still not home free. Acquirers will want to know where that EBITDA comes from. Do you have a broad, diverse base of customers? Have they signed long-term contracts with you? Are your prices in line with the market?

I know a guy in an industry where some companies are going for three or four times sales. He'd like to sell his business and can't understand why no one wants to buy it. The trouble is, he has a couple of big customers that contribute more than half of his sales, and they're paying through the nose. That can happen. Maybe an account has grown over time, and the customer isn't getting the discounts it's entitled to. Maybe the person overseeing the account is incompetent or not doing the job properly. Whatever the reason, you make out like a bandit in the short run, but you have problems in the long run. As soon as the customer wakes up, you'll lose its business. Smart acquirers will note the danger and discount your business accordingly -- or decide it's not worth buying.

But let's assume you have a well-run company. What you can get for it will probably be somewhere between five and eight times EBITDA. (I'm excluding Internet-based "concept" companies here, or at least those with the potential for explosive growth, which get valued according to a set of rules all their own.) The exact multiple depends on various factors, such as interest rates. As they go up -- and money becomes more expensive -- the multiple tends to fall. If they go down, the multiple rises. It can also be affected by the amount of competition among potential acquirers and the number of good businesses available, as well as other factors related to your particular company. Unused capacity, for example, might boost the price. But in the end it will be somewhere between five and eight times EBITDA no matter what industry you're in.

Why? Because what acquirers buy is the potential to make money in the future. The more money they're likely to make, the more money they're willing to pay. Conversely, the greater the risk that the cash flow will be cut off prematurely, the less they're willing to pay. Yet, as obvious as that may seem, it's not how people in your industry will talk about what an acquirer has paid for your company after you sell it. In fact, it's probably not how you'll talk about the price you got. Instead you'll convert it into a multiple of sales or some other rule of thumb that everybody is familiar with. In the records storage industry, for example, we often hear that someone has sold a business for so many dollars per box. That may literally be true if the acquirer has bought only the accounts and the boxes that go with them, but if the whole business has been sold, the rule of thumb is just a form of shorthand. Regrettably, it gives people like the father-and-son shredding team the wrong idea about their company's value.

So does all this mean the father and son will never be able to sell their business? Not necessarily. I doubt any rational human being will pay $1.2 million for it, but it might have value to the right type of buyer, namely, people much like themselves. The first question is, does the business generate enough cash for someone else to earn a living from it and still have money left over to make monthly payments to the father and son for, say, five or six years? The second question is, would that be a better deal for the buyer than simply starting from scratch?

I can't answer those questions, but the father and the son might want to do so before they start counting the money from the sale of their business.

Norm Brodsky is a veteran entrepreneur whose six businesses include a three-time Inc. 500 company. His co-author is editor-at-large Bo Burlingham.