Part 6: Understanding price implications of financial metrics
This is Part 6 of a multipart blog series on negotiating the price of a small business. If you missed the previous post, read about understanding the price implications of industry fundamentals here.
When it comes to valuing a small business, now is where things get a little more real, and more quantifiable. Indeed, the business model characteristics and industry factors discussed in Part 4 and Part 5, respectively, are primarily qualitative in nature and may go undiscussed altogether when it comes to buying or selling a small business.
That said, a company’s financial performance is highly quantifiable (and comparable across alternative investment options), so even if you avoid disagreement on the previously discussed qualitative factors, it is much harder to avoid sharp debate on the following financial characteristics of a target company:
- Margins. A small business that earns higher margins – particularly at the operating (or EBITDA) level – is typically regarded as more valuable because greater profitability means higher potential to self-fund additional growth, greater capacity to service debt and/or a higher return for owners.
- Cash Flow. That said, great margins on the income statement should not be mistaken for strong cash flows (though they are often correlated). Indeed, astute small business buyers are likely to want additional information on the cash flow efficiencies of a target company, focusing on how much capital expenditure (i.e., investment in assets or “capex”) and net working capital (i.e., investment in accounts receivable and inventory, net of accounts payable) is required to keep growing revenues and earning profits. A business that has lower capex and working capital requirements and faster cash conversion cycles (i.e., turns a sale into cash quickly) is often seen as more valuable, because it requires relatively less cash to generate relatively greater returns.
- Solvency & Liquidity. Often a product of healthy margins and strong cash flows (not to mention prudent financial management), a business that is solvent (i.e., it has enough assets to cover its long-term liabilities) and liquid (i.e., it has enough cash to service its short term obligations) is more valuable than a small business that is close(r) to bankruptcy, because it’s on sound financial footing and less likely to fail.
- Historical Performance. A business that has been growing steadily for years and can show consistent financial performance year-on-year is almost always more valuable than a company with more erratic results, because profits are seen as more predictable.
- Capital Structure. A small business that has no (or, the “right” level of) debt is more valuable than a company that has too much, because first and foremost, there is greater cash flow to shareholders. Additionally, there is less risk of the company being crippled by debt repayments in a downturn or suffering from debt overhang, and more chance of a prospective small business buyer being able to borrow to (partially) finance an acquisition, which reduces illiquidity (see more under Growth Potential: Recapitalization below).
- Contingent Liabilities. Experienced small business buyers are especially weary of “unseen” liabilities that may exist but are not explicitly documented in standard company records (e.g., pending lawsuits, future warranty claims, possible regulatory fines, or debts sitting in other related entities etc.). As a result, a business that has no contingent or “off balance sheet” liabilities is more valuable than a firm that does, because there is no (or at least less) risk of unforeseen obligations arising.
- Inappropriate Accounting. Just like experienced buyers worry about what they cannot see in a target company’s financial statements, sometimes they worry about what they can see that shouldn’t be there. Indeed, many small business owners use their company (whether knowingly or not) as a conduit for asset purchases or expenditures that are more personal in nature, or not market-related. This then creates some personal tax advantage for themselves or their families, for example paying inflated rental on a family-owned property, paying a spouse a salary for no services rendered, or expending the construction of a vacation home. The obvious challenge with such accounting practices (beyond being criminal in many jurisdictions) is that a new owner may be saddled with a future tax liability, if, as and when the inherited irregularities are reported to tax authorities. For this reason, a small business that has completely “clean” accounting policies and tax records is always seen as more valuable.
As a small business owner, it is certainly difficult to manage all of these metrics and issues completely in your favour, all the time. That said, unlike many of the industry factors discussed in Part 5, they are all within your control – especially if you “start early” and actively manage these factors well before the sales process is initiated.
To learn more, keep reading Part 7 in our Negotiating the Sale of a Small Business series, where we look at the people-related dynamics in a target company that can enhance value. A reminder, a complete version of this content is available to EquityMaven’s subscribers in e-book format.