Buyers may buy cash flow as a return on investment (ROI). Buyers typically want a business that keeps doing what it has been doing and generating cash flow reliably, which is perceived as presenting the lowest risk model. Whether a small business or a global enterprise, this is the most popular reason to buy a business.
The business valuation is driven by looking at the financials historically and then confirming after assumptions (ex. where everything stays the same) that the business is worth buying. Some ROI buyers will value a business as worth 3 years net cash flow (3X) or 5 years net cash flow (5X) or 10 years net cash flow (10X). The multiple is driven by a many moving pieces (to be discussed in a future post).
Private investment parties and individuals will complete due diligence on the history of financial performance. They will “smell test” the company’s ability to continue forward, model market influences and trends, and look for least amount of variation (risk). Once the high confidence model is established the details are provided to the number crunchers that provide a multiple calculation adjusted for the foreseen variables.
Before you decide that 10X seems like an exaggeration we have completed a transaction where the private parties paid 8.5X normalized EBITDA for a private mom and pop business. The rational for the ROI buyer was based on the revenue generated from the company’s 10 year supply and service contracts. The average shelf life remaining on the existing contracts was 7-8 years and the company was signing on new clients regularly. The buyer clearly saw the advantage of reliable future cash flow reducing risk and the once they developed market knowledge of the large potential client base and low competitive pressure this transaction became very valuable to the buyer.
Business owners who manage their business cycles and cash flow for consistent results year over year will find interested buyers constantly trying to buy in. Business owners with bumpy cash flows can find it difficult to attract serious return on investment buyers to the table regardless of the unique flavor of their business model.
We will discuss buying to expand an existing business the next post.