As M&A advisors we take a lot for granted.  When we talk with business owners about their options we often throw around buzzwords like "Discounted Cash Flow," "Net Present Value," and "EBITDA" and assume that by using these short cuts we are simplifying things.

Early in my career I was talking to a potential client and I learned a valuable lesson.  These phrases and concepts are not widely used by many business owners and rather than helping to explain our approach they actually ended up adding to the confusion. The gentleman I met with said, "spare me the gobbledygook, just walk me through how a buyer might value my business."

Since then, I've learned a great deal about the techniques, methods and shortcuts buyers use to value companies. While most buyers build spreadsheets to help them do the math, the spreadsheet helps either confirm or debunk, the buyer's basic, gut intuition regarding value.  As a result, I think it is often just as important to understand the thought process most buyers go through to reach their conclusions rather than just understanding the terminology and math behind business valuations.

First Question: How much money will the business make in the future?

The first thing a buyer will estimate is how much cash flow your business is likely to generate each year for the foreseeable future. Of course, this is a highly subjective question, so buyers come up with their best guesstimate by looking at a number of things including:

• Contracts you have that guarantee revenue into the future
• Repeat sales or recurring revenue that is likely to come in the future
• The investment in time and money it takes to acquire a new customer
• Past profitability and growth rate
• Industry growth rates and profitability

Buyers spend a lot of time trying to understand these points and will "model" your business using a spreadsheet so they can plug in different assumptions and see how your business will perform under different conditions.

The smartest buyers spend less time coming up with endless scenaries to test out and more time understanding and validating the assumptions that go into the spreadsheets.  So it pays big dividends if you are prepared to prove or support whatever assumptions you tell a buyer they can rely on.

Second Question: How much am I willing to pay today for cash I might get tomorrow?

Once buyers have a sense of how much cash your business will generate in the years to come, they ask themselves what are they willing to pay today for money they might get in the future. For example, would you pay or invest $1,000 today if you knew for certain that you'd get $1,100 in one year. If so, you felt that the net present value of $1,100 a year from now is $1,000 today. In this example, you'd be generating a 10% percent return on your money.

Question #3: What are the chances that I won't get the expected stream of cash?

Once buyers have figured out how much cash your company is likely to generate in the future, and what they would be prepared to pay today for that future cashflow, they will estimate how risky that future cash flow is.

For example, if in the example above, you were guaranteed to get $1,100 back in one  year, you would have a risk free investment.  Unfortunately, buying a business is not risk free, a lot of things can go wrong, and more often than not projections of future cash flow are wrong.  They are either too low or they are too high.

For example, if you felt there was a 50% chance that you might get $1,100 a year from now, and a 50% chance that you might only get $900 back.   If you weigh the probability of the outcomes, you would only receive $1,000 back.  That might cause you to rethink whether you would be willing to pay $1,000 to only get $1,000 back a year from now. In order to get a 10% rate of return you would only be willing to pay $910 today for $1,000 in the future.

So, the level of perceived risk and the buyers' expected rate of return are directly related. The riskier the future cash flows are, the higher the buyers' expectations of a return will be - and the lower the price they are willing to pay today for cash flow in the future.  And, keep in mind that buyers have lots of other options for investing their money including the public stock market, bonds, treasury bills, and more.

Given the hightened risk of owning a private company and the fact that you can't sell it as easily as selling a publicly traded stock or bond, investors demand a higher rate of return than they could get with these other options.

Key Takeaways:

• Buyers only pay for a future stream of profits (the past is only valuable in that it helps them predict the future).
• If your future cash flow is unpredictable, buyers will demand a higher return on their investment and offer a lower price for your business.

My advice is to focus on what drives the thinking, even if that means looking past the equations: how can I predict and justify the future cash flows my company will generate, and how can I minimize the perceived risk in the minds of potential buyers.  If you would like to discuss some ways to do this, please contact the MidCap Advisors office nearest you.