3 Critical Factors That Make Or Break The Value Of Every Small Business

How much a buyer is willing to pay for a small business is driven by three critical factors…the amount, growth, and stability of the expected future cash flow the business can provide to that buyer.

Any small business buyer expects a return on their investment of capital and time (as an owner/operator).  This return is provided by the future cash flow of the business.  The greater the amount, growth, and stability of this expected future cash flow, the more a buyer is willing to pay.

Amount

How much annual cash flow does the business generate?  It goes without saying, all things being equal, the more cash flow a business generates, the more it is worth.

For example, Red Company generates $100,000 per year in cash flow, while Blue Company generates $50,000 per year.  Assuming the same pricing multiple (or discount rate) applied, Red Company will sell for twice the amount of Blue Company, no matter the multiple.

Buyers don’t care how much blood, sweat, and tears a seller has poured into the business.  If it doesn’t make money (provide cash flow), it probably isn’t worth any more than the liquidation value of its assets.

Growth

Negative growth is the kiss of death when it comes to value.  The fact is that the vast majority of potential buyers won’t even consider a business that is in decline in either revenue or cash flow.  In these situations one or two things generally happens: either the business owner puts their nose to the grindstone, turns around the business and sells it a few years later, or the business owner rides the business down, milking what is left until the day comes to turn out the lights, permanently.  Unfortunately, the latter happens most frequently.

Conversely, a high growth business can command a much higher price than one with lower expected growth.  Consider this:  two businesses in the same industry, each earning $100,000 in cash flow.  Company A is expected to grow annual cash flow by 5% per year for the next 5 years, while Company B is expected to grow by 10%.

The difference between 5% and 10% may not sound like much, but over time, this difference is significant.  In this example, Company B earns $90,000 more than Company A over 5 years, and earns 26% more in Year 5, making it much more valuable to a future prospective buyer, even if the future growth rates (Year 6 and beyond) were expected to be the same.

Buyers will pay more for growth because growth means more cash flow…it’s as simple as that.

Stability

The final critical factor is stability of cash flow.  Businesses with recurring customers typically are more stable than ones with one-time customers.  CPA and accounting firms have recurring revenue…engineering firms do not.  While both are professional service firms with similar cost structures, you can probably guess which one is valued more highly?

Construction-related businesses have typically had the revenue and cash flow stability problems, as well.

Just consider this:  two businesses with the same total projected cash flow over the next three years.  Company X has cash flow projections of $100K, $120K, and $140K.  Company Y has cash flow projections of $30K, $260K, and $70K.  While both have a total three year cash flow of $360K, which one is more desirable to own and manage?  Which one would a buyer pay more to own?

For some businesses, predicting future cash flow is a relatively straightforward and easy process.  Vending machine companies, for example, are usually able to estimate their revenue and cash flow within a narrow range of possibilities.  For other businesses, typically ones with large contracts for one-off jobs, predicting future cash flow with any level of accuracy is practically futile.  The best one can expect is a wide range of possibilities.  Consider the following example.

Company 1 is a very predictable business with moderate growth.  Therefore it has a very narrow range of expected future cash flow outcomes, with an average of $360K.  Company 2 is a highly unpredictable business, and the further out, the less predictable it is, hence the wider ranges of expected future cash flow for each subsequent year.  Even though the average total future 3 year cash flow for Company 2 is significantly higher than Company 1, it is likely that Company 1 would attract more buyers and sell for more money than Company 2 due to its stability.

So it is important to remember, whether one is a prospective buyer or seller, the amount, growth, and stability of the expected future cash flow are the three critical factors that drive value in every small business.