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In this series, we discuss the BEI's Seven Step Exit Planning Process. We started with a comparison of Exit Planning and succession planning and followed that with establishing the foundation for an owner’s plan: the owner’s goals.
In this article we discuss cash flow - a critical element of quantifying any gap between an owner’s personal and financial resources today and those they need when they exit their companies to live the post-business life they desire.
It is not uncommon for business owners to ask their advisors, based on conversations they’ve had (or overheard) with other owners, “Do you think I can get a six times multiple for my company?” How do you respond?
You really cannot respond until you define “the what” exactly is being multiplied. This article describes the importance of making certain your owner-client, you, and the buyers in the marketplace use a common definition of the “what.”
Cash Is King
“Cash is King” is a favorite phrase of investment bankers since the certainty of future cash from a seller’s business can minimize the buyer’s risk in the transaction. Buyers, however, make a slight variation to the phrase: “Cash flow is King.” Why? Few cash buyers are willing to part with their money unless they see the likelihood of a steadily increasing stream of cash flowing from the business, after they acquire a company. For that reason, this article explores the definition and importance of cash flow when selling a business to a financial buyer—the most common type of buyer.
Cash Flow and OPM
Today’s financial buyers are both anxious and selective about acquiring companies. They need to deploy the capital they’ve raised from investors or return it. At the same time they are using less financing to acquire companies and more of their own (and their investors’) capital. They can’t afford to make costly mistakes. They seek companies that have increasing cash flow, good growth potential, and strong fundamentals (such as a strong management team and good operating systems). Of course, these characteristics have always been important signs of a good company. But, given the fact that buyers are reaching into their own wallets for fifty percent (or more) of a purchase price, minimizing risk by basing their acquisitions on strong target company cash flow has never been more critical.
Cash Flow and Risk
Acquiring a business with strong cash flow reduces a buyer's risk in a transaction. Therefore, for many owners/sellers, the chance to receive maximum prices for their companies depends on current and future cash flow. It is cash flow, often described as EBITDA, that truly is king. While most owners are familiar with the term “EBITDA,” that doesn’t mean that they understand or use it in the same manner as professional buyers do.
Definition of Cash Flow
There are several definitions or measures of cash flow, each with a potentially significant and substantive difference. For that reason, investment bankers will agree with a seller that they can get any multiple of cash flow sellers ask for as long as you let them define “cash flow.” The devil truly is in the details, or in this case, in the definition.
Typical measures of cash flow include Earnings Before Interest and Taxes (EBIT) and EBITDA. Another measure of cash flow is the amount of pre-tax money actually distributed to owners via salary, bonus and distributions from the company such as S-distributions and rental payments in excess of fair market rental value of the equipment or buildings used in the business.
Each of these measures of cash flow produces a different cash flow amount. Once the parties agree on how to measure cash flow, don’t forget the seller’s need to recast cash flow by adding back items such as excess rents and excess salary or bonuses paid to the owner and his or her family.
Which brings us back to our original question, “Do you think I can get a six times multiple for my company?” We suggest your response should be to first ask questions that enable you to understand what owners believe they are multiplying. The message for those of us who are Exit Planning advisors but don’t work in M&A is: make certain that owner clients share with us their definitions of cash flow and related terms (such as EBITDA). Equally important is asking the investment banker or business broker on your advisor team to review a client’s financial information and determine EBITDA, EBIT, and cash flow in the same way as buyers do. Only then is it possible for the advisor team you lead to develop a range of likely sale price for your clients’ businesses.
A major objective in this second step of the Exit Planning process is to develop accurate information regarding your owner-client’s financial resources rather than relying on the owner’s opinion. Knowing the starting point—an owner’s existing resources—is fundamental to developing an accurate road map.