In past issues of The Exit Planning Review™, we have looked at why cash flow is so important to third party buyers, and by extension, to sellers of closely-held companies. In short, a seller must demonstrate an increasing stream of cash flow from the business. Without a healthy cash flow, a buyer may pass over the opportunity to buy your business in favor of purchasing a “good” company with less risk.
In this issue, we will examine why cash flow is also crucial to those owners who wish to transfer their companies to insiders (employees, co-owners or children) and how to allocate cash flow.
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A Decision Framework
If you contemplate transferring your business to an insider (employees, children or co-owner) and you want to get paid the value of your business, then, generally speaking, the value of your business cannot exceed four times the true cash flow of the business (as illustrated in the previous issue of The Exit Planning Review™). We have defined true cash flow as the amount of pre-tax money distributed to owners via salary, bonus, distributions from the company such as S-distributions, and rental payments in excess of fair market rental value of the equipment or building used in the business. Let’s look at how cash flow determines the sale price to insiders.