Private equity firms look for a specific combination of traits in an investment: strong and predictable cash flow, a defensible competitive position, a capable management team willing to put its own money into the deal, clear room to grow the business, and a realistic path to selling it within roughly six or seven years. Every other criterion sits underneath one of those five. Because these firms typically finance 60 to 90 percent of the purchase price with debt and hold the company for a defined period before selling, each screen is really a question about whether the business can service that debt, grow during the hold, and be sold at a profit at the end.
Predictable Cash Flow and EBITDA
Financial health is the first filter, and it is measured almost entirely through EBITDA — earnings before interest, taxes, depreciation, and amortization. That figure strips out financing and accounting choices so buyers can see how much cash the core business actually produces. The median buyout in 2025 priced at 11.8 times EBITDA, and deals over $500 million averaged closer to 15.8 times over the prior five years.1McKinsey. Global Private Markets Report 2026 A company generating $10 million of annual EBITDA at an 11x multiple would be valued at roughly $110 million.
Raw profitability matters less than the consistency of it. Because so much of the purchase price is financed with debt, the buyer needs confidence the business can cover interest payments year after year without straining. Federal tax law reinforces that caution: business interest expense is deductible only up to 30 percent of adjusted taxable income, so buyers avoid targets whose earnings barely clear their debt service.2Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Recurring revenue, long customer contracts, and low capital expenditure needs all push a target up the priority list. A company that doesn’t have to constantly reinvest in expensive equipment keeps more cash available for paying down debt and funding growth.
A Defensible Competitive Position
A durable moat protects the value of the investment over a five-to-seven-year hold. Buyers look for barriers that stop competitors from copying the product or undercutting the price: patented technology under federal patent law, trademarks registered under the Lanham Act, trade secrets, and deep customer relationships that would be painful to unwind.3Office of the Law Revision Counsel. 35 U.S. Code 1 – Establishment
Pricing power is the clearest evidence a moat exists. A business that can raise prices without losing meaningful volume has customers with few good alternatives. High switching costs strengthen the effect: a customer integrated into a software platform or supply chain faces real financial and operational friction if it tries to leave. Firms test for these advantages by looking at gross margin stability. Margins that hold up through inflation or a downturn show the moat working under pressure.
Environmental, social, and governance factors have moved into this analysis too. Weak data-privacy practices, opaque supply chains, or governance problems create exposure to regulatory penalties, consumer backlash, and reputational damage — all of which are expensive to remediate mid-hold and can shrink the pool of eventual buyers.
Management Willing to Invest Alongside the Firm
The firm can rewrite the balance sheet and set a new strategy, but management runs the business day to day. Buyers want leaders with a track record of hitting financial targets and steering companies through transitions. Existing executives are usually asked to stay several years to preserve institutional knowledge and customer relationships, and a documented succession plan matters because losing a single executive shouldn’t unravel the investment.
Alignment gets enforced financially. Executives are typically required to invest their own money in the deal, and restricted equity grants are common. Many executives make a Section 83(b) election, which means they pay income tax on the stock’s value at grant rather than at vesting. If the company appreciates during the hold, that gain is later taxed at the long-term capital gains rate instead of as ordinary income.4Office of the Law Revision Counsel. 26 U.S. Code 83 – Property Transferred in Connection With Performance of Services The election has to be filed within 30 days of the transfer and cannot be revoked, so it’s a decision executives make early and cannot unwind.
Non-competes protect the investment from the other direction. When a firm pays a premium for a business, it needs assurance that founders and senior leaders won’t walk out and start a competitor. Non-competes tied to the sale of a business are generally enforceable, though state law varies on duration and geographic scope. The FTC finalized a rule in 2024 that would have broadly banned non-competes, but a federal court blocked it and the agency later dropped its appeal.5Federal Trade Commission. FTC Announces Rule Banning Noncompetes Even under the blocked rule, non-competes entered as part of a good-faith business sale were explicitly exempt.
Room to Scale
Growth potential is measured by whether revenue can rise without a proportional rise in cost. Buyers want a large addressable market, so there’s real room to expand through new products, new customer segments, or new geographies. The target during the hold is often to double or triple the size of the business.
A buy-and-build strategy is one of the most common growth playbooks. The firm acquires a “platform” company and then uses it to roll up smaller competitors in a fragmented industry, capturing purchasing power, shared overhead, and cross-selling opportunities. Deals large enough to trigger federal antitrust review must file under the Hart-Scott-Rodino Act before closing; the threshold sits at $133.9 million as of February 2026.6Federal Trade Commission. New HSR Thresholds and Filing Fees for 2026 Scaling efficiently usually depends on standardized technology, reporting, and operating procedures that can be dropped into every add-on acquisition.
A Realistic Exit Path
Private equity firms invest with a defined timeline. Average holding periods across the industry now exceed six and a half years, with sectors like telecom and energy closer to seven.1McKinsey. Global Private Markets Report 20267S&P Global Market Intelligence. Private Equity Buyouts Record Longer Holding Periods in 2025 Before writing the initial check, the firm needs a plausible way to sell the company later and return capital to investors. A target that meets every other criterion but has no clear exit route usually gets passed over.
The common exits are:
- An initial public offering, where the company files a Form S-1 with the SEC and sells shares to the public. IPOs can generate the highest valuations but depend heavily on market conditions.8U.S. Securities and Exchange Commission. Form S-1 Registration Statement Under the Securities Act of 1933
- A strategic sale, where a larger corporation in the same industry buys the business to extend its capabilities, customer base, or geographic footprint.
- A secondary buyout, where another private equity firm acquires the company on the theory that further operational work or a different growth strategy can extract more value.
- A continuation fund, where the firm transfers the company into a new vehicle it manages, letting existing investors cash out or roll forward. Continuation fund transactions reached an estimated $63 billion in volume in 2024 as an alternative when IPO and M&A markets slow.9CFA Institute. Continuation Funds: Ethics in Private Markets, Part I
What Happens After the Letter of Intent
Meeting the criteria gets a target to a signed letter of intent, not to a closed deal. Firms run 60 to 90 days of due diligence before wiring funds, and they build financial mechanisms into the purchase agreement that shift some risk back onto the seller after closing.
Due Diligence
The centerpiece of financial diligence is a Quality of Earnings analysis. Unlike an audit, which confirms historical statements follow accounting rules, a Quality of Earnings report adjusts for one-time events, normalizes revenue, and establishes a defensible earnings baseline for the valuation. Buyers review at least three years of financial statements, tax returns, customer concentration data, and receivables aging, along with any correspondence with tax authorities and outstanding audits.
Legal diligence searches public records for liens, judgments, and pending litigation that could become post-closing liabilities. UCC filings show whether a lender already holds a security interest in company assets; other searches cover federal and state tax liens, bankruptcy filings, and active lawsuits. Anything unresolved becomes a negotiating point: a price reduction, an indemnification provision, or a reason to walk away.
Earn-Outs and Escrows
Earn-outs tie part of the purchase price to future performance. If the business hits agreed revenue or EBITDA targets after closing, the seller receives additional payments. Outside life sciences, the median earn-out has recently represented roughly 30 to 34 percent of the closing payment. Sellers usually prefer revenue-based targets because revenue is harder to manipulate; buyers usually prefer EBITDA-based targets because they capture profitability. The choice of metric, and the precise formula for calculating it, is one of the most heavily negotiated points in any deal.
Indemnification escrows hold back part of the purchase price in a third-party account to cover losses if the seller’s representations turn out to be wrong. Without representation-and-warranty insurance, the median escrow runs about 9 percent of the purchase price with a survival period near 18 months. With insurance in place, the escrow often drops below 1 percent and the survival window shortens to around 12 months. Either way, sellers should expect a portion of proceeds to sit locked up until that period ends.