Cash flow and quality of earnings
By John F. Dini, CMBA, CExP
Financial buyers, Private Equity Groups and Family Offices, acquire companies based on their Return on Investment (ROI). When the owner of a mid-market company receives an offer from a financial buyer, he or she logically expects detailed due diligence on the business’ assets and income. Once they have proven the numbers shown on the balance sheet and income statement, most owners expect the transaction to proceed. Unfortunately, that’s not always the case. Merely dissecting your customers, lines of business, contracts, one-time expenses and unrecognized liabilities isn’t enough. Quality of earnings examinations also examine how your cash flows. The auditors who conduct these reviews look for possible events that will require further commitment of capital from the investors, which would logically reduce the ROI.
Just selling at a decent margin isn’t enough. That margin suffers from invisible erosion if your customers don’t pay on time. I’ve heard plenty of owners say “They are our best customer, even if they don’t pay for 90 days.” Buyers may look at that as “financing” the customer’s average balance. Even if you aren’t borrowing for working capital, that is money that could be more efficiently used elsewhere. The math of earnings quality assigns an interest rate to those funds. If the customer takes three months to pay, and maintains an average over-30 balance of $500,000, a 6% cost-of-funds calculation could lop $30,000 from your earnings. If the offered multiple is 5x, that’s $150,000 deducted from your sale price.
Try our free cash flow solution, CashSage.
Working Capital Needs
Another oft-heard claim by sellers is “This company could grow a lot, if only we had more capital.” Don’t be surprised if an experienced buyer tries to use that to lower their price. I don’t think either of these deductions is necessarily fair. If your valuation is based on past performance, then what the buyer plans for the future is his problem. Slow payments or missed opportunities are already reflected in your income statement. They have little to do with the profitability underlying your value. Nonetheless, some buyers will put a planned working capital infusion on the table as a negotiating tactic. On the other hand, if your selling price includes projections of future performance, or there are obvious issues of deferred maintenance (your computers still run on Windows 7 for example), then expect an attempt to adjust the purchase price to compensate for the additional cash needed right after closing.
Most of us anticipate that a fast growing company will demand a higher multiple than a slow-growing or flat business. That doesn’t mean a buyer won’t try to “double dip” by offering both a lower multiple and discounting for performance in the post-LOI due diligence period. Angry sellers will exclaim “But you knew my numbers before you made the offer!” True, but if an outside auditor emphasizes a lack of revenue or profit growth in his report, it is likely to be on the table again. It will absolutely be an issue if your growth rate falters during due diligence. It’s hard to go through the machinations of a transaction and pay attention to driving the company at the same time. Just be aware that taking your foot off the gas will be noticed, and accounted for. The bigger issue is when growth on your top line isn’t equaled or exceeded on your bottom line. It may indicate that you are “buying business” with discounting. Failure to increase margins in proportion to additional volume may point to a lack of scalability. Either will become a part of the discussion on final price.
The Underused Statement
There are four basic financial statements. The Statement of Shareholders Equity (usually seen only in audit reports) is unimportant in a transaction, since the equity is ultimately determined by the selling price. Most owners understand the correlation between Balance Sheets, Income Statements and business value. However, because the company’s cash position is an integral part of day to day management, many owners pay little attention to the Statement of Cash Flows. It could contain traps that impact your final selling price.