Understanding Cash Flow Impact On Your Company's Value
John had come to us with high expectations for the price he thought his company would sell for. He was certain of this because he had seen other companies sell for a similar multiple of gross revenue. However, what John had failed to understand was that buyers are only partly interested in top line revenue. More important to negotiating the selling price of most companies is the net cash flow the company produces. John's bottom line failed to live up to industry standards, which meant he wasn't likely to achieve the exit he had envisioned.
We have identified the top 12 principal reasons we've seen which have caused business owner transitions and exits to be unsuccessful. Each of these reasons impacts the company's ongoing annual profitability as well as an owner's transition and future exit results. This article addresses the second of these 12 reasons:
Reason #2. Cash Flow Impact On Company Price Misunderstood.
You haven't understood your exit is dependent upon an inside buyer's or third-party buyer's expectations and needs regarding your company future cash flow and you haven't uncovered or understood how your company's exit-appropriate buyer-specific valuation is to be determined.
A universal ownership objective is to secure the income stream you will need to support the lifestyle you and your family plan to enjoy. Knowing the value of your business is critical if you are to successfully complete the transition growth and exit planning process. Knowing this value - and knowing how this value is determined - becomes critically important.
During the transition and exit planning process, a number of different types of business valuations are often discussed. These different types of valuations all tend to have the same objective, which is to establish a value for your ownership interest in the business which you (or your family in your absence) expect to receive, or would be satisfied to receive, in full exchange for your ownership interest. These differing types of valuations can come into play at or during various parts of the exit process.
Your business valuation initially provides some idea as to what your company is worth, as a means not only to provide you with an estimate of the value which your efforts have achieved, but also to provide your advisors with a valuation estimate for their planning purposes in helping you to achieve your objectives.
One of the most commonly used methods of determining a company's value is the EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) multiple method. This method reflects a valuation of the business enterprise operations without a deduction for depreciation, amortization, or income taxes, and without reflecting the interest inherent in the debt structure of the company. The EBITDA to be used might be the most recent year or some simple or weighted average of the past few years, or a reasonable projection of the coming year or years. The multiples typically range from 4 to 7, although a smaller or larger multiple may apply, depending on the quality of the company and its expected future prospects.
As an example, if the EBITDA for the company is $1,000,000, and the appropriate multiple is 5, then the business (before debt) is worth $5,000,000 for purposes of that valuation. If you have $2,000,000 of interest-bearing debt on the balance sheet, the value of your ownership (equity) in the company would be $3,000,000.
To arrive at a valuation estimate (and to determine exit options and key employee retention alternatives), your exit advisors must have a good estimate of the expected annual cash flow your business can generate. Without this, a realistic transition growth plan cannot be successfully developed.
The EBITDA method is just one of the methods for arriving at some indicated valuations for your company. This does not represent a substitute for a good company business appraisal by a qualified business appraiser.
However, this does provide a way to develop a preliminary valuation, which is very useful in the transition growth and exit planning process. This is because the preliminary valuation can be arrived at fairly quickly, which can help keep the transition growth and exit planning process moving forward without the need for an interim stoppage to obtain a full business appraisal.
Our Next Step Transition Growth and Exit Planning program has been specifically designed by us to address and overcome each of the 12 principal reasons for failure. This program consists of 12 critical building blocks. We are using this program around the country to help business owners design and implement their transition growth plans for accomplishing their transitions and exits successfully.
Andrew D. Horowitz, CPhD, is a wealth advisor and president of The Estate Management Group. The firm's website is www.EMGPlanning.com.
Nicholas K. Niemann, Esq., is a transition and exit planning advisor and a partner in the law firm of McGrath North. The firm's website is www.McGrathNorth.com.