| When buying a business, it is amazing to see how | | | | frame of mind has been established. Let's take an |
| many people misunderstand value. Many value | | | | example: We are being offered a business which |
| business the same way as a product is valued. A | | | | generates a cash flow of $100,000 per year. We |
| product is valued based on all the costs involved in | | | | require a 50% ROI which is not unreasonable given the |
| producing it or purchase price paid for it to a supplier. It | | | | general risky nature of businesses and the work the |
| stands to reason then that the cost involved in setting | | | | buyer will have to put into it once the business is |
| up a business ("Organizational Costs"), the assets the | | | | purchased. |
| company controls, Inventory and other such assets | | | | Our scenario would be based on the formula: |
| would represent an appropriate value for a business. | | | | Cash Flow/Purchasing Price = ROI or $100,000 |
| That would be an incorrect and very dangerous | | | | $200,000 =.50 |
| mistake. Right out wrong! Did it make an impression? | | | | Therefore, the savvy buyer would offer $200,000 for |
| Good. A bit harsh, but I want to make a point here. A | | | | this business. Usually, a seller offering the business at |
| business, in much the same way as an investment, is | | | | one times cash flow (100% ROI) is looking for a quick |
| valued based on its Return on Investment ("ROI"). | | | | all cash sale. Whereas, one asking 3 times cash flow is |
| Let's use Certificates of Deposit ("CD") as an example | | | | a seller not as motivated to sell. However, the latter |
| because CDs under $100,000 are considered risk free | | | | seller might be willing to offer financing and other |
| instruments. Therefore, given the choice between two | | | | concessions. For now, you should have an idea of |
| CDs, one would pick the investment with the highest | | | | how to use cash flow to value a business. |
| yield or ROI. In much the same manner, when given a | | | | Another trap to avoid is the hype about sales with a |
| choice between two businesses, all things been equal, | | | | grain of great potential. Sales onto themselves are |
| the savvy buyer would pick the one with the highest | | | | meaningless as a way of valuation. It is what the |
| ROI. Cash Flow is much like interest on CD, and it is | | | | business owner takes home at the end of the day |
| used to calculate the yield on the investment or, in this | | | | that matters. Almost all companies have sales, but far |
| case, the purchase price of the business. | | | | less actually make a buck. Another pitfall along those |
| So what is Cash Flow? Businesses generate sales | | | | lines that can be avoided by thinking cash flow is |
| and after deducting expenses, they are left with a net | | | | development costs ("Sunk Costs") which happens a lot |
| amount ("Net Income/Loss"). The difference between | | | | on the ecommerce and technology arena. Sellers |
| Net Income and Cash Flow is that the former reflects | | | | often claim many thousands of dollars were spent |
| cash and non-cash expenditures of the business. Cash | | | | developing a site. They are implying that since these |
| flow or Operating Cash Flow to be more exact is | | | | costs have already been incurred, the buyer is ahead |
| ONLY concerned with cash sales and expenses. If a | | | | of the game. Often times, the venture has not been |
| business cannot generate money from its main | | | | launched and requires further money. In reality, many |
| operations, then it is likely that it will not be able to | | | | times the sellers are victims of cost overruns and are |
| continue as going concern for long. | | | | trying to bail out and recuperate some or all of their |
| Cash is good for two reasons: | | | | initial outlay. |
| 1) It is easy to verify with a bank statement, | | | | There might be valid assets the seller expects you to |
| 2) Non-cash expenses are based on management | | | | pay such as inventory, land, building, Machinery etc. |
| estimates and, hence, can be manipulated or the | | | | Business brokers might or might not include some of |
| numbers polished as it is known. One example is | | | | these assets in the price as it is often the case when |
| depreciation, which is based on a depreciation method | | | | buying a store. Therefore, you will need to ask the |
| and the asset's useful life. Guess who calculates both? | | | | seller if the price includes these assets. Still you will |
| You got it the seller. Depreciation expense can have a | | | | need to consider the overall return on your investment, |
| significant impact on Net Income, but not on cash flow. | | | | and operating cash flow is a good way to start. |
| Alright, now let's put it all together. Hopefully, the right | | | | |