In the last column we talked with a business owner named Jim who asked me how he could be confident that his business will be valuable and salable when he reaches the time to leave his business. We discussed the big picture factors that determine salability and value—cash flow and risk. Also we talked about needing to carefully position a business to attract buyers and achieve the highest price.
In this column, we will explore the factors that have real world impact on value and salability. Whether the exit plan involves a sale to management, a child, or a third party, the factors we will discuss are decisive.
Cash flow is king. Buyers need to make a living and get a return on investment. Cash flow is necessary to support outside financing. All of my banker friends are fond of cash flow when financing a business acquisition.
What about cash flow is important? The most valuable cash flow is (1) Reported, (2) Consistent, (3) Growing and (4) Expected to continue in the future.
Reported cash flow is important because business valuation relies heavily on a multi-year profit history in order to project future cash flow. Some businesses are operated to minimize reported profits. Major mistake. I see dollars flying away in the wind every time I read financial statements that do not show the pure performance of the business. It could be a family trip to Hawaii (competitive research expense), personal trips to Costco (office supply expense), your son’s racecar sponsorship (marketing expense), or the salary of a child who is away at college. I understand tax deductions, but the dollar value of higher profits in a sale will far outweigh any loss of tax deductions. Although your financial statements will be recast in a sale to reflect true earnings, buyers place a higher confidence on non-adjusted earnings. (Note: Profits are not the same as cash flow, but we will assume they are the same in this article.)
Steady cash flow gives a buyer higher confidence in future returns. Profits that vary 40% from year to year will require a buyer to budget for lower profits. Similarly, seasonal or cyclical cash flow during a year means that a buyer must invest more working capital to fund operations, whether it be cash or a line of credit. One distribution company invests cash equivalent to 30% of annual revenues into inventory leading up to their peak season. That significantly raises the amount of capital that must be invested in the business and lowers the valuation.
A growing company with a business model and market to support continued growth will command a significant value premium over a stagnant company. Cash flow growth brings an expectation of higher value in the future. Some business owners believe their company "could grow if the right buyer comes along". That is an admission that the company does not currently possess the assets, the people, the product/service, the market position, or the strategic plan to grow. It implies that the only reason for growth will be new resources that a buyer brings to the table, and, in most cases, a buyer will not pay a premium for what they bring to the table. To achieve a growth premium, a company must prove that it has the ingredients to continue growing.
It is the first three characteristics of cash flow—reported, steady and growing—along with other internal and external factors, which give the expectation of cash flow continuing in the future. Buyers of companies invest for the future. They look for a confidence of future cash flow. As confidence increases, the value increases.
Cash flow is the single most important factor in value and salability, so guard it and grow it!
Bryce DeGroot is the president of Compass Advisors, a regional specialist in business sales, acquisitions and valuations. He welcomes comments at 406-282-6000 (x801) or email@example.com. This article is not legal or tax advice