The Role of Cash Flow
The concept of small business valuation has created challenges in the marketplace for years. Unfortunately, unlike publicly traded stocks, there has been little formal education offered in the business schools and accounting classes traditionally on the subject of small business valuation. While value can have a completely different meaning to various individuals based on perspective, there are some standard principles that are taught by respected organizations such as the International Business Broker Association (IBBA) and accepted by valuation experts around the world. In fact these principles that we will discuss below are practiced by the Small Business Administration (SBA) as the approved method to small business valuation.
There are a number of different ways to value a business including the Discounted Cash Flow Method, Market Multiple Method, and Asset Value Approach. Each of these different methods to approach the valuation of a small business can be appropriate for different applications however we will not cover these in great detail in this article. The most widely used method for valuing small businesses is the Market Multiple Method.
Understanding how to interpret cash flow statements for small businesses is an important first step in valuing a business. The IRS regulations related to small business expense guidelines allows a good deal of room for interpretation. The application of these regulations can vary significantly between one business owner and the next. As a result, the financial statements for small privately held businesses often reflect some expenses for items not traditionally considered business-related. In addition there may be other non-cash or other expenses such as the seller's amortization and/or depreciation expenses that are not directly transferable to a new owner.
In order to review financial data in a consistent manner the industry has developed a standard process call Recasting, Normalizing, or Stabilization. This concept has been adopted by the appraisal industry, CPA’s, attorneys, the International Business Brokerage Association (IBBA), and the Small Business Administration (SBA) as the accepted approach to standardizing financial information.
Expenses that typically are adjusted/recast/stabilized/normalized and taken out of the Profit & Loss statement, to arrive at the "true cash flow", include owners salary, owners benefits (life insurance, health insurance, pension plan), debt service, depreciation (non-cash expense), and charitable contributions. Other expenses may be adjusted based the unique business owners accounting methods.
The adjusted (stabilized) expense information is applied to the original cash flow for the business to arrive at an adjusted cash flow. This is the actual net cash benefit to the business owner. This adjusted number is referred to as Net Owner Benefit (NOB) and/or Sellers Discretionary Cash Flow (SDC).
In a manner very similar to appraising a single family house, business appraisers continually solicit information on sold businesses across the country. Professionals are encouraged to submit transaction details (without disclosing the actual name of a business) to the database, and in exchange are awarded access to the database for professional reference.
Multiples (or ratios) can be derived by comparing selected variables such as annual sales, gross profit and SDC to the Sales Price. Due in part to the volume of transaction information, applied to businesses in similar industries, these multiples can provide a very accurate picture of valuation (as defined by the marketplace).
In practice, regardless of the formal approach to valuation, and the calculated value of a specific business, the business is only worth what it can produce in terms of current cash flow and future returns to the buyer. Buyers and lenders look at the ability to earn a realistic salary for operating the business while producing enough cash flow to comfortably cover debt service, and generating a fair return on invested capital (ROIC).
A common way to determine the seller's Discretionary Cash Flow is by using an analysis known as EBITDA (Earnings of the business Before expensing the seller's Interest, corporate income Taxes, Depreciation and Amortization). Also deducted from the business expenses is any owner's compensation or benefits the company paid. The result of this analysis is to leave in the expenses any recurring, non-elective "core" expense that the buyer is likely to also experience when the buyer takes over the operations of the business.
The resulting Discretionary Cash Flow then represents the factor that then is usually used as a multiple in determining what the business is "worth", based not on the assets present in the business, nor on it's potential, nor on it's history/reputation/good will, nor on any factor but on it's ability to generate cash flow.
Most small businesses that are successfully sold will sell for a multiple of 1 to 3 times the SDC/NOB. Some larger businesses might sell for 4 to 5 times SDC/NOB. The variables that affect whether a business is priced at 1 or 2 or 3 or 4 or 5 times NOB/SDC are determined by (a) the SDC/NOB involved (businesses with smaller SDC/NOB usually sell for lower multiples), and/or (b) assets included in the sale, and/or (c) the appearance of the premises, and/or (d) the trend in sales/profits in recent years, and/or (e) the customer mix of the seller's business, and/or (f) the strength/weakness of the business' staff, and/or (g) the availability of seller financing for some of the purchase price, and/or (h) any number of other factors that might impact on value/price.
ABMI, having successfully brokered the sale of thousands of different businesses over the last almost 30 years, has a keen understanding of all these issues, and offers to consult with buyers or sellers, by appointment, to help you understand these facts, that are so important to entrepreneurs who wish to buy, sell or finance a business.
Entrepreneurs (business buyers or sellers) who wish to arrange a free, no obligation consultation to discuss "Cash Flow" or any other topic about buying, selling or financing a business, may phone ABMI at 913-341-6300 or register with this ABMI web site, and we will then contact you.