I recently made a presentation to a group of area business brokers and accountants discussing the captioned subject. I thought you might be interested in the presentation outlines, which boil down to one thing: Cash is King!
1. Cash Is King!
A. Cash flow to equity (CFE) is the REAL bottom line for business owners
B. Because businesses can spend, invest, or distribute cash, not earnings
C. Owners try to minimize earnings (and taxes) and maximize CFE
D. Short CFE definition: change in cash before dividends, after all else
E. Long CFE definition: formula and example (business appraisers know this)
2. Cash Is King!
A. Show buyers projected CFE, not just EBIT(DA) or net income
B. For firms with declining revenue, CFE may exceed net income if working capital decreases, but this is not sustainable
C. Show 5-year forecasts: prepare complete financials (I/S, B/S, C/F)
D. Use realistic forecasts, no hockey sticks; buyers will not pay for potential
3. Cash Is King!
A. Justifiable valuations are based on cash-on-cash return on equity (ROE)
B. ROE = cash earned divided by cash paid
C. Return = CFE (net of fair market owner-manager compensation)
D. Equity = buyer’s cash purchase price (excludes assumed business debt)
E. Buyer (personal) borrowings to finance cash purchase count as equity
F. ROE = C. ÷ D.
G. Capitalized cash flow value D. = CFE ÷ ROE
4. Cash Is King!
A. ROE is the cost of equity (discount or hurdle rate, required rate of return)
B. For small businesses (sales > ~$1 MM), ROE ought to be at least 20%
C. This rate of return does not vary much over the economic cycle
D. This is because buyers have a long-term horizon
E. Similar to mezzanine money rates of return – risky!
F. Maximum ROE is 40% (venture capital required rate of return)
5. Cash Is King!
A. ROE requires that buyer-manager earn a fair market salary (ROL)
B. ROE requires that business adequately service debt (ROD)
1) Pay annual interest (Coverage = EBIT / Interest Expense)
2) Repay current principal (Coverage = OCF / Principal due this year)
C. For micro businesses (sales < ~$1 MM), there must be ROL and ROD, but there may be no ROE – “own or buy just a job”
6. Cash Is King!
A. Be wary of fixed asset appraisals (real estate, equipment)
B. Exposure times are longer and values are down
C. Ask for forced and orderly liquidation values (latter is basis for loans)
7. Cash Is King!
A. Base earn-outs on net revenue collected (cash receipts from sales)
B. Easy to audit – see bank statements
8. Cash Is King!
A. Bank financing is now very hard to obtain … and for how long?
B. Requires more buyer equity, more seller financing (and longer terms)
9. Cash Is King!
A. Make sure sellers understand that selling price and proceeds may differ
B. (Forget about taxes to keep things simple)
C. Most deals are asset sales, not equity sales – avoids liability transfer
D. Include retained assets and liabilities in proceeds calculation
10. When in doubt … Cash Is King!