What Others May See

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What the Buyer Sees When Pricing a Company

The pricing point from the buyer is whether the cash flow from the business will justify the purchase price for the business.

The basic formula is as follows:

Cash / Price Formula
1. Take the:
owner's discretionary cash flow
use a 3-year average
2. Reduce this by:

Annual debt service:
this will include the principal and interest payments for financing the purchase price of the business less the down payment
___________________

Owner or manager annual salary:
the market rate for managing the business either as the owner or through a hired manager
___________________

Capital Expenditures:
the amount that must be paid to maintain, service, and replace business equipment and other fixed assets. A good benchmark is to replace all operating assets within five years. Take the market value of the operating assets and divide by 5
3.

Equals:

Remaining Cash Flow:
this amount needs to be positive to justify the asking price
Example:  
Estimated Price: $550,000
Buyer Down Payment (1/3rd): $181,500
Financing Terms: $368,500
10.0%
7 year note
Market Value of Operating Assets: $35,000
Estimated Return on Down Payment: 5%
Forecasted Annual Cash Flow $210,000
minus:  Annual Debt Service $73,410
minus:  20% Debt Service Cushion*

$14,682
minus:  Owner / Manager Salary $100,000
minus:  Capital Expenditures $7,000
minus:  Return on Down Payment $9,075
Cash Flow Remaining $5,833

The asking price is justified in this example given the positive cash flow position after deducting financing cost, management salary, return on the initial investment, and capital expenditures.

*Note: Standard cushion required by lenders when underwriting this loan. This amount is not an expense and would be an additional amount to cash flow.
Another Example:  
Estimated Price: $650,000
Buyer Down Payment (1/3rd): $217,644
Financing Terms:

$432,356
10.0%
7 year note
Market Value of Operating Assets: $35,000
Estimated Return on Down Payment: 5%
Forecasted Annual Cash Flow $210,000
minus:  Annual Debt Service $86,131
minus:  20% Debt Service Cushion*

$17,226
minus:  Owner / Manager Salary $100,000
minus:  Capital Expenditures $7,000
minus:  Return on Down Payment $10,882
Cash Flow Remaining ($11,239)

By increasing the asking price another $100K with everything remaining equal, the cash flow position from the buyer's perspective is negative and does not support the asking price.

*Note: Standard cushion required by lenders when underwriting this loan. This amount is not an expense and would be an additional amount to cash flow.


What the Lender May See

The lender is interested in two things:

  1. Does the historical cash flow (and projected cash flow) cover the cost of financing with a 20-25% cushion in the event of economic or market turndown?
  2. If in the event of a default, can the bank recover the financing by selling the company assets?

If the answer is "no" to question 1, the lender will not finance the deal.

If the answer is "no" to question 2, the lender may finance the deal if you (via the buyer) can demonstrate that the business is a growing entity that support increasing cash flow.

Lenders assume a lot of risk when financing business purchases. Their only security in the event of default is the operating and fixed assets.

Lenders will not lend on goodwill and brand equity. They are looking for a business that has been managed well, has a management plan in place to grow the business, and has a history of financials that support the projected earnings expected.

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