Once a company has grown beyond the small business realm, it could become attractive enough that outside investors want to own it. When this happens, these investors may offer to buy the company. With few exceptions, the primary source of value for an operating business that generates good returns on capital is the earnings power, not the assets on the balance sheet. For example, manufacturing plant machinery isn’t worth much when bought on the liquidation market, but when acquired as part of an on-going company that produces large profits, it is valuable.

Investors will look at the earnings of the business and factor in growth, debt levels, and the economics of the industry as a whole. If things are attractive, they often apply a valuation multiple to the profit stream. This is the equivalent of the price-to-earnings ratio you hear so much about in the stock market. Thus, a business that earns $1 million per year in profit might reasonably sell for $10 million or $15 million. That figure is the “capitalized” earnings value of the firm.

Some small business owners form new ventures for the sole purpose of growing them to the point the earnings can be capitalized and the company sold. This is known in financial terms as a “liquidity event.” There are even special types of investors that focus on this niche investment strategy, such as so-called “venture capitalists” who back nascent enterprises in the hopes of someday taking them public in an IPO or selling them to an established player in a market.

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