business valuation comes down to cash flow

this step needs to come before proper financial planning can occur.

by ed mendlowitz
77 ways to wow!

business owners contemplating retirement should obtain a business valuation to determine the value of the business and whether the other resources will provide financial security. the conversation and successful engagement also require that the valuation analyst understand the owner’s motivating factors, or the qualitative information.

more: 50 ways to create value for business owners and board members | what earnings mean for a business valuation | why and how to track payroll costs | use constraints to make improvements | the role of strategy in pricing | wow clients with trend analysis | 26 ways to wreck a financial projection
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obtaining the right price is important but holding out for a larger value and deeming all other values lower than that as a “deal breaker” can be self-defeating to the owner seeking financial security. there are other ways to obtain the security. further, quibbling over a smaller amount can potentially undermine the long-term plan, which is to retire.

a person who owns a business will occasionally need to have it valued. an important reason for valuing a business is to plan for the owner’s long-term financial security. unless the value is understood and used properly, misleading information can have deleterious effects.

the value of the business could be completely objective or based on what the owner believes the business is worth or would like to hear what it might be worth. but in a financial plan, this could be deceptive. the purpose of the plan is usually to assist in making a “retain in the family” or “sell” decision.

the purpose of the financial planning should be concerned with expected and needed (to retire) cash flow, and not asset valuations. the valuation process is needed before the potential cash flow can be determined, but the cash is what is used to live on, not the asset value. the financial plan should also consider the cash flow the seller can expect to receive from the business, under the various scenarios, including if the owner ceases to be fully active.

once the valuation is completed, adjustments are made from the sale proceeds for income taxes, broker’s commission, professional fees, and other costs such as extended liability insurance, warranty allowance, staff bonuses to encourage remaining with the business, or severance pay.

further, the sale might not be all cash. a substantial portion could be paid with notes, based on future profits, or client or customer retention. there might also be requirements for the owner to work in the business for an extended time. these all need to be considered and quantified in the financial plan. only then can the cash flow be projected.

as professional advisors, our job is to present numbers to the client, so they make an informed realistic choice. however, the first choice for the client is to decide how they want to spend the rest of their life.

many entrepreneurs love what they do and rarely think about retiring. unless they plan on working until they drop, they need to consider what they really want for themselves. retiring doesn’t mean retiring from life. it is entering the next stage of life. assuming good health, regardless of age, someone retiring can look forward to at least 15 to 20 or more productive years in which to pursue another interest devoid of the need of having to make a living. the pressure is gone, and the only concern is the desire to follow a path that could create a benefit, fuel interest and lead to involvement with new people, ideas and causes. it will also enable the owner to extricate themself from any problems while running a business, having people depend on them for too much, and being forced to make decisions under stress and without adequate information.

running a business is work. work is done to earn a living and acquire sufficient funds to live securely when no longer needing to work. it would seem work should end when the security is obtained, based on anticipated future needs.

many people are conflicted on what they would be doing after giving up running their business. they may have no hobby or overwhelming desire to accomplish something else or they may be afraid they will sit around doing nothing. we all hear stories about people dying soon after retiring because they lost their passion, feeling of importance or identity, but they are stories and not individualized histories. life itself is a passion and should be enjoyed. if someone lost their passion for living because they gave up work, well, how exciting was the life they lived?

when talking about retiring, i always think about benjamin franklin, who retired at age 42 by selling his business for half of its earnings for 18 years. by surrendering half of his income for all of his time, he was able to spend the remaining 42 years of his life developing the theory of electricity, helping found the united states of america, inventing bifocals, and watching the first manned balloon ascend and descend in paris, among a great many other things. he did not go mad as many in business assume they will if they retired.

drill down to cash flow

many valuation specialists analyze the business and prepare realistic appraisals, and clients like the high numbers to place on their personal financial statements.

but the analysis needs to drill down to cash flow. the cash flow could end up appearing to be inadequate, especially in an era of low interest rates. and the owner could decide not to sell, instead drawing out as much cash as they can, running the business into the ground, which can take many years. this would possibly result in a greater cash flow than if they sold the business.

working and working and working does provide more cash flow, but it also requires physical presence. winding down carries a risk of having the right people in place, as is an unplanned-for disability.

proper planning requires effort, cost and a degree of luck to assure the right personnel are in place.

one of the models we should prepare, in anticipation of making the critical decisions, is the potential cash flow from continuing with the business, alternative cash flow possibilities from existing investments and retirement accounts and any other source of cash flow such as social security.

we should also help the client determine their expected spending needs when they are no longer active in the business to illustrate whether they will have sufficient cash flow. all our projections need to be well considered and realistic. our energies will be spent helping the client make a one-time-only decision that impacts how they will be spending the rest of their life.

the client who fails to plan and implement for the various contingencies places his cash flow and the legacy at risk.

while we are at it, we should illustrate the differences in cash flow, based on different amounts received for the business. in the long run, the price received is not the major factor – it is the cash flow. the client should not make getting less than “the right price” the deal breaker.

holding out for an extra $1 million (not an amount to denigrate) after additional selling costs and taxes could net out to $500,000. the $500,000 at a supposed 4 percent net after tax yield is $20,000 a year, plus an added bequest of $500,000. the extra $20,000 probably will not make a huge difference in the owner’s life and the $500,000 – if it’s that important – could be covered with life insurance at a fixed annual cost. this is the left side of the “t” account. the right side is 100 percent of the owner’s time.

the money or the owner’s life

the financial plan has a purpose and often that purpose is overlooked with the value used serving the owner’s ego rather than the practical aspect of the plan, which is as a tool for the client to use to assess their future financial security. cash flow is what will be spent, not the value.

posted on september 18, 2023