Risk and Cash Flow = Deal Price  

Failure to understand and manage the risk inherent in every business is a leading reason for bad deals. The negotiated price between buyer and seller in theory reflects the inherent risk in a business. Therefore it follows that when the buyer underestimates risk he or she over pays. And when the seller allows negative misconceptions as to risk, he or she will get too low a price. It's simple.

What is risk? Risk is anything and everything you can possibly think of that might reduce future cash flow. Some risks are minuscule and simply ignored while others are closer to home. In fact, some risk factors are common for all businesses while other risk factors are specific to a particular business or industry. The seller's goal is to minimize risk factors. The buyer's is to understand and identify them.

Here are a few examples of what risk can be:

• Loss of a major customer.
• Loss of a key employee.
• New technology in the industry.
• New competition.
• Personal health issues of an owner/manager.
• Change in government regulations or requirements.
• An increase in interest rates and/or a decrease in credit availability.

The transaction price for most businesses is the function of two factors:
cash flow and risk

Simply put, the buyer wants a return on his/her investment. The bigger and faster the cash return, the more a buyer is willing to pay for a business. However cash flow is in the future and without a guarantee. Thus, the buyer has to adjust the calculated purchase price for the possibility cash flow will not materialize. Ergo, a higher perceived risk will lower the purchase price. And there's the rub for a lot of sellers - the buyer perceives a risk that is either nonexistent or overstated.

Example: A large customer of SELLCO is sold. Does this mean reduced sales for SELLCO in the future? Therefore a lower value for SELLCO? Maybe. But assuming CUSTOMER continues to need the same product or services, this could also mean higher sales for SELLCO in the future. If SELLCO can reach an understanding with CUSTOMER and its new owner, SELLCO can turn a perceived disadvantage into a plus.

Conversely, if a buyer misses a big risk factor, he or she will surely overpay. I have seen this happen. In one extreme case I came into a situation where the buyer had overpaid an excessive amount and lost everything through personal bankruptcy.

Beacon can help you analyze risk in either your own business or a target opportunity. We can also offer advice as to how to reduce risk making your business more valuable. Give me a call if you have any questions.

Regards,

Jon Fudeman

Beacon Equity Advisors  

Coming up in future newsletters:

• How to prepare a business for sale.
• What buyers are looking for?
• Using a contingent sales price.
• What is cash flow?