A vital issue to the sale of any small business is the Seller understanding his/her own Cash Flow position, as it applies to a potential sale.

It is amazing how few Business Owners understand this issue.  Many operate out of their check books, feeling that if they have money left at the end of the month, that is good enough for them!

Keep in mind that we are not Accountants, we do not pretend to be Accountants and we do not even play Accountants on TV!  The discussion provided here must be viewed in that light; however, the term “Cash Flow” is quoted in any number of documents and reports as a “non-GAAP” financial measurement, anyway.  (GAAP itself is defined as the Generally Accepted Accounting Principles by which Accountants operate.)  Cash Flow is utilized as a term most frequently by non-Accountants, as well.  You see it in the vast majority of advertisements and other promotional materials, when Sellers and Brokers offer businesses for sale, but also in more technically oriented documents such as quarterly and annual reports from some of the Country’s largest companies.  However, in those latter documents, Cash Flow is normally, specifically labeled as a “non-GAAP” measurement of financial health.

That’s not to say it is an invalid measurement; but what it does mean is that it is something that has a wide variety of definitions and you, as a potential business Seller, need to understand what each individual Buyer or Broker is using to measure his/her definition of Cash Flow.  The absolute only way to do that is to disclose your own definitions, whenever information about your business is presented.

We are really going to discuss what Cash Flow means to the average Business Owner and Broker, (contrasted with what might be meant in a public company’s Annual Report,) with the emphasis that even here, there are broad variations in definitions.  The Seller or Broker should be able to explain him/herself in great detail.  If you provide vague answers, it is an invitation to the Buyer to back off of the deal.  The perception will be that you are playing games, or that you do not know what you are doing!  You or your Broker should be able to tell the Buyer – in writing – what methodology has been employed in a Cash Flow report, and why.

Cash Flow is not even a universal term.  Brokers will frequently label terms like “Sellers Discretionary Cash” (SDC).  EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) which is a more descriptive term than any of the others.  But it is not necessarily as all-encompassing as what is normally thrown into either Cash Flow or SDC.  There are many, many other terms used by many, many individuals, particularly in small businesses.  So again, you absolutely need to provide documentation, or ask your Broker to do so, in writing.

(We are currently involved in a C-Store negotiation, and the Broker admitted in advance that she was a novice.  She kept saying that the Seller was “making about $13k a month…”  The term “making” was vague, but in fact meaningless to us:  Was that Gross?  Net?  Adjusted Net or Cash Flow?  She was terrific in answering all questions in what she meant in great detail, and certainly was not hiding anything.  But the example demonstrates that lots of people use lots of different terms, none of which are standardized and demand clarification.)

Generally speaking, Cash Flow is comprised of, Net Profit, ideally as claimed in the Seller’s Tax Returns, plus Adjusted Expenses such as:

  • One-time items purchased by the Seller, which either would never to be replaced, or would not need to be replaced within the next number of years.
  • Expenses that the new Owner will not inherit, like the loan the Seller is paying off for when he/she bought the business; the Buyer will have his own loan, but the Seller’s own loan will be retired with the settlement, as will his payments.
  • Non-cash expenses, such as depreciation and amortization.
  • Some Tax Expenses.  (This is where your Accountant is invaluable!)
  • Any payments the Seller has made that are absolutely not part of the business expenses. (We once saw three salaries in a business, but no employees; I asked the Seller about it and he said those were he three grandchildren, all of whom were in kindergarten, first and second grades.)

This last issue is where arguments usually start. There are some adjustments that should not be legitimate business Expenses, but extracting them and proving they are not germane to the operation is difficult, if not impossible. The Seller that argues that issue is not very wise, in many instances.  For one thing, these individual items are frequently not terribly large, and pushing the Buyer to accept them will frequently create more of an air of suspicion or negativity than they are worth.

Even if those Expenses are not part of the business, Buyers will not be able to get any lender to agree to honor those adjustments, when the bank is using the Cash Flow for the purpose of granting a loan.  Moreover, if the Seller puts this in writing, he/she is opening him/herself to scrutiny from the IRS, which could very well then see such comments as a confession to Tax Fraud; the Broker that cooperates could have some liability in this area, as well.

Some Sellers/Brokers put the Seller’s entire Salary into the adjustments. This is not wrong, but the Seller/Broker should disclose this in advance, and the Buyer should know that this needs to be adjusted again for him/herself, when applying for a loan to fund the acquisition.

The Seller’s Fringe Benefits are another area that need to be understood.  As a general rule, if the Seller has an established IRA or other Retirement programs for himself and for which the Company is paying, these are added to the Cash Flow.

Health Insurance is commonly added back in, as well.  If it is not specifically required to continue the daily operations of the business, the Seller/Broker is completely justified in adjusting such an Expense and adding it to the Cash Flow total.  BUT YOU NEED TO BE ABLE TO DISCLOSE AND EXPLAIN YOUR METHODOLOGY!

Also, be very careful to understand that all Cash Flow and the resulting recast P&Ls you create in using such information, is based on historical data; it is the result of your (the Seller’s) own activity and methods of operation.  Cash Flow is used as the basis for pricing the sale of many small businesses.  IT IS VITAL THAT NEITHER YOU NOR YOUR BROKER DOES ANYTHING THAT WOULD SEEM TO EVEN HINT THAT THESE FIGURES CONSTITUTE ANY KIND OF A GUARANTEE THAT THE BUSINESS WILL CONTINUE TO EARN AT THIS LEVEL!!!!  Any assumptions should be solely made by the Buyer, him/herself.  This is the area where most lawsuits occur.

Cash Flow issues are the most crucial areas of the transaction.  It is the basis for attracting Buyers, and their understanding and faith in your disclosures is vital to whether the deal will be adversarial in nature from the beginning, or whether they will decide to move forward, at all.  And it provides you with an idea of whether your Buyer pool will be able to get financing, once the two of you agree to terms.  It sets the pattern for everything that follows!

(The BAF Group LLC is a full service Business Brokerage, with a history of more than a decade of service. Its Principal Broker possesses 25+ years of Business Sales and Divestiture. Although most of our work is involved in the Mid-Atlantic States, we have represented Sellers and Buyers throughout the Continental USA, and a number of overseas Buyers, as well. Some of our listings and additional information about us can be viewed at www.bafgroup.com. Or, you may contact us at combroker@bafgroup.com. Thank you for your interest.)