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Cash flow is a critical element in quantifying gaps between owners’ personal and financial resources and the resources they need to exit their businesses on their terms .
Based on conversations they’ve had with or overheard from other owners, business owners commonly ask their advisors a variation of the following question: “Do you think I can get a six-times multiple for my business?” How would you respond to this question?
You cannot answer this question without first precisely defining “the what” (i.e., the thing being multiplied). This post stresses the importance of assuring that you, your client, and buyers in the marketplace create a common definition of “the what.”
Cash Is King
Investment bankers often use the statement “cash is king” because buyers desire to minimize their monetary risk when purchasing a seller’s business. However, most buyers prefer the phrase “cash flow is king” because they will refuse to purchase a business without a strong likelihood that the purchased business will exhibit a steady and consistent cash flow after purchase. This post will examine the definition and importance of cash flow to owners (i.e., sellers) when selling their businesses to the most common type of buyer, the financial buyer.
The Importance of Defining Cash Flow
The definitions of cash flow are nebulous and numerous, and each definition can have a substantially different effect on owners looking to sell their businesses. Thus, investment bankers often can answer in the affirmative when sellers ask whether they can get them a certain cash flow multiple for their businesses, with the caveat that the investment bankers are allowed to define what cash flow means. The devil is in the details, or in this case, the definition.
Most definitions of cash flow consider earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA) primarily. Others determine cash flow by the amount of pre-tax money actually distributed to owners via salary, bonuses, and distributions from the business, 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 the above mentioned definitions yield different cash flow amounts. Thus, interested parties need to make sure that they use the same definition of cash flow in their purchase or sale consideration. Additionally, sellers must recast their cash flow by adding back items such as excess rents and excess salary or bonuses paid to the owner and his or her family.
Cash Flow and Other People’s Money
Financial buyers tend to be both anxious and selective when acquiring businesses, primarily because they must either use the capital they’ve raised from investors (which implies paramount responsibility) or return it. Concurrently, financial buyers are using less financing and more money from their own (and their investors’) coffers, which makes costly mistakes intolerable. Financial buyers look for businesses with increasing cash flow, good growth potential, and strong fundamentals, such as a committed management team and turnkey operating systems. Though these elements always have been important determinants of a strong business, the fact that buyers are spending 50% or more of their own capital to purchase businesses makes risk minimization—most commonly assured by targeting businesses with consistently strong cash flows—crucial.
Cash Flow and Risk
Targeting businesses with increasing cash flows minimizes buyer risk. Thus, current and future cash flows often determine whether owners will receive the maximum price for selling their businesses. Cash flow truly is king, which is why it is imperative for sellers to assure that they and their potential buyers use the same definition of cash flow. Though EBITDA is the most commonly used definition of cash flow and most owners are familiar with EBITDA, owners still must be vigilant in confirming that all parties are defining cash flow similarly, lest they sell their businesses short.
So, Can I Get a Six-Times Multiple?
Going back to the original question, “Do you think I can get a six-times multiple for my business,” we suggest that you answer this question with some questions of your own. First, ask questions that will help you understand what owners think they are multiplying. For Exit Planning Advisors who are not a part of the mergers and acquisitions market, you must assure that owner-clients share their definition of cash flow and related terms (e.g., EBITDA) with you. You also must contact the investment banker or business broker on your advisor team to review the client’s financial information and define EBITDA, EBIT, and cash flow the same way buyers do. Only then can you and your team provide your client with an accurate range of sale prices for his or her business.