This series discusses The BEI Seven Step Exit Planning Process™. We started with a comparison of Exit Planning and succession planning and followed that by establishing the foundation of a business 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 current personal and financial resources and those they need when they exit their companies to live the post-business lives they desire (Step Two).
It’s relatively common for business owners to ask their advisors, “Do you think I can get a six-times multiple for my company?” based on conversations they’ve had (or overheard) with other owners. How should an Exit Planning Advisor respond?
It’s impossible for either the business owner or the Exit Planning Advisor to answer that unless they define “the what”: Exactly what is being multiplied? This article describes the importance of making certain your that owners, Exit Planning Advisors, and the people (or entities) that buy the owner’s company use a common definition what is being multiplied.
Cash Is King
“Cash is king” is a favorite phrase of investment bankers, since a buyer’s risk in purchasing a seller’s business is minimized by the certainty of future cash from the seller’s business. However, buyers 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 it. Thus, we will explore the definition and importance of cash flow when selling a business to a financial buyer, the most common type of buyer.
Cash Flow and Other People’s Money
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 (e.g., a strong management team and good operating systems). Of course, these characteristics have always been important signs of a good company. However, given that buyers are reaching into their own wallets for 50% or more of a purchase price, minimizing risk by basing their acquisitions on a company’s strong targeted 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 (Earnings Before Interest, Taxes, Depreciation, and Amortization), that truly is king. Unfortunately, while most owners are familiar with the term EBITDA, they often don’t understand or use it in the same way as professional buyers.
Definition of Cash Flow
Because there are several definitions of cash flow, each with a potentially significant and substantive difference, investment bankers will tell sellers that they can get any multiple of cash flow they ask for, as long as you let them define “cash flow.” The devil truly is in the details, or in this case, 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 distributed to owners via salary; bonuses; and company distributions, such as S-distributions and rental payments exceeding the 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, the seller must 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.
This brings us back to our original question: “Can I get a six-times multiple for my company?” To answer this appropriately, BEI Exit Planning Advisors first ask questions that enable them to understand what owners believe they are multiplying. This allows them to make certain that their business-owner clients share their definitions of cash flow and related terms (e.g., EBITDA).
It’s equally important for Exit Planning Advisors to ask the investment banker or business broker on their Advisor Teams to review a client’s financial information and determine EBITDA, EBIT, and cash flow the same way buyers do. Only then is it possible for the Advisor Team to develop a range of likely sale prices for the owner’s business.
A major objective in Step Two of the Exit Planning Process is to acquire accurate information regarding the business owner’s financial resources rather than relying on the owner’s opinion. Knowing the starting point—a business owner’s existing resources—is fundamental to developing an accurate road map.