When I was in the business of buying entrepreneurial companies, the first thing we’d look at to determine the value is the cash flow. If you want the option to sell your business someday — it might make sense for you to pay attention to your cash flow now!
Most businesses are valued based on a “multiple of cash flow.” Smaller companies, with cash flow under one million dollars, might be purchased for 2X – 5X cash flow. A larger company with a strong track record of growth in a desirable industry might command 8X – 15X cash flow. But the base number was the most important — how much money is the company producing that the owners could take out of the business and spend on whatever they wanted to.
How to calculate cash flow
To get that number we’d start with the company’s profit, as shown on the P+L, and we’d add back the interest, taxes, depreciation, and amortization. Interest and taxes change depending on how the owner finances and operates the business — they aren’t inherent in the business operations. Depreciation and amortization are non-cash accounting charges that get added to the P+L to account for “using up” assets over time. Subtracting all of those out gets us to EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization.
We would also take out any costs that were directly supporting the owner. If there were any personal travel costs or perks (Cars, phones, etc.) or entertainment (meals, sports tickets, etc.) that flowed through the business we’d take those expenses out. Then we’d adjust the owner’s salary to reflect a “market” salary for a position like theirs.
The resulting number would tell us what economic value was being created by the enterprise. It helped to determine the business’ worth.
What’s your business worth?
Does your business provide you with significant cash that you can invest outside the business above and beyond a market rate salary? Are you taking some of that money out to diversify your risks, or are you plowing it all back in to grow your business?
If you want the option to sell your business at some point then you want to work to maximize the cash flow that your business produces. Growing your margin is as important as growing your revenue.
On Thursday we’ll talk about the value created by building a great team!