Cash Flows Drives Business Sales

“They were a people so primitive, they did not know how to get money, except by working for it.” – Joseph Addison

One of the most contentious issues business owners must confront when deciding to sell their business is establishing a fair price. To really understand the number of opinions on this issue, pay a visit to the Business section at any local library.

You’re likely to see entire books written on this subject. So many variables are involved, many of which are subjective, that different “experts” looking at the same company often formulate different recommendations.

There is the Capitalization Rate method, the Debt Capacity method, the Critical Factors method, etc. However, what a business is really worth is what a buyer is willing to pay, and a seller is willing to accept.

Since this ultimately depends on some common ground between the buyer and the seller, one of the most effective methods is the “cash flow” method, derived from business’ cash flow.

Buyers typically are comfortable with this method because although they are buying a business, what they are really buying is its cash flow. Cash flow is not simply the business’ net profit. It is the business’ net profit combined with the owner’s salary and personal perks plus interest and depreciation.

When a business’ cash flow is identified, different multipliers can be applied to determine a fair market range for the business. Multipliers vary depending upon the type of business. For example, a manufacturing facility likely would have a higher multiplier than a service business.

Many other factors can also affect the multiplier. For example, new product development, strong market share and a diversified customer base (i.e. having no one customer represent more than 10 percent of sales) can positively impact the multiplier.

Conversely, outdated inventory, declining market share and the risk that key personnel could leave the business and disrupt operations might have a negative impact. Often not given consideration is the effect that the transaction’s terms have on the deal.

An all-cash deal or a transaction with a large down payment will give the buyers a reason to expect a discount on the sales price while on the other hand, a smaller down payment will cause the seller to expect a higher sales price.

For many owners, one of the most troubling aspects of the cash flow method is that there is no mention of assets, furniture, fixtures, equipment or inventory. That’s because while those items contribute to establishing cash flow, they by themselves have limited value.

Therefore, when an owner is considering selling their business, looking at different evaluation methods may have some value, but only when they are related to the business’ cash flow.

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