How Cashflow & Assets Have An Outsized Influence On Business Buyers’ Decision to Purchase A Business
Sellers often have a fantasies of selling their businesses for unrealistic amounts. Reality steps in often in the form of a business broker who has to provide down-to-earth calculations. While there are several ways of preparing business valuations, ultimately the buyer and seller have to have a meeting of the mind to perfect the deal. Figuring out what’s on the buyer’s mind is advantageous for a seller’s ability to actually sell their business. Usually, the most important factors for business buyers are either revenue or assets.
The Cashflow Model essentially involves valuing a business that is profitable. The business cash flows and has been profitable for several years. Valuations use historical financial statements to look forward on the premise that revenue and profit will continue indefinitely.
Business brokers and lenders typically analyze the last 3 years of business tax returns and the most recent Profit & Loss (P&L) statement to find the annual cashflow of the business. The method is called Seller’s Discretionary Earnings (SDE) and essentially involves adding back the seller’s deductions that were nonessential to the business, discretionary or one-off expenses.
For example, let’s say Cashflow Carrie deducted expenses related to her children’s mobile phones, her Tesla and her contract attorney who litigated a breach of contract case for her business. Carried deducted those expenses to reduce her tax exposure but now these same deductions negatively impact her business value. Fortunately, her business broker knows to add-back these expenses to increase her cashflow because the kids phones are nonessential to the business, the Tesla is not necessary for business purposes rendering it discretionary and the lawsuit was a one-off expense.
Once the cashflow is determined, then the business broker will identify the multiple of revenue for the business by comparing market data for similarly sold businesses. Back to our example, let’s say that Cashflow Carrie’s industry is typically valued at 2.5 x SDE. If Carries’ Seller’s Discretionary Earnings is $200,000, then her business would be valued at $500,000.
Lenders will look to the seller’s SDE to approve financing. Buyers typically make a cash deposit payment (10-20%) and then finance the rest. Lenders look to the business cashflow to assure that sufficient earnings to provide the buyer with a livable income and cover the debt-service.
Business Asset Model
Where the business does not cash flow, value is determined in the business’ assets. Physical assets like equipment, land, buildings, machinery and/or vehicles often make up the bulk of the balance sheet. Since 2000, however, intangible assets are now overtaking physical assets in value and a buyer’s desirability. The brand, systems, data, intellectual property, designs, contracts and positioning are all considered to be far more valuable than physical assets.
Assets are typically assessed in value by valuation experts. In commercial real estate, appraisers are hired to determine property value. For equipment, machinery, there are specific valuation experts and/or the parties will determine market value on resale platforms for their industry. For vehicles, the parties often agree to readily available online tools like Kelly Bluebook. Like physical assets, there are also valuation experts for patents and other intangible assets. Otherwise, industry-specific experts might be hired to provide insight as to valuing their relevant equipment, machines, tools, etc.
For many entrepreneurs, finding an asset rich business (either tangible or intangible) provides a huge leap in manifesting their business plan at a reduced cost than individually buying components, securing a location, developing their intangibles, etc. With the right creativity, these assets provide a huge return on investment with a solid business plan.
Contact us today if you’d like to discuss either valuation model regarding the possible sale of your business.
The information shared here is for informational purposes only and is not intended nor should be construed as investment, tax, financial or legal advice. Should you need professional advice, consult with a licensed professional concerning your specific situation.