Capital Investments, Business Valuation and Selling Your Business

John Brown owned a successful janitorial supply company. After 22 years he decided to upgrade his facilities and made a major investment in a new office warehouse and all the related shelving, computers, and furnishings. John and his accountants estimated that the $250,000 reduction in yearly cash flow was more than made up by the likely long term return on investment from potential business expansion.

When John went to sell his business 9 months later he was shocked to learn that his improvements had:

Reduced the current value of the business at that time by 45% or $1,250,000.
Reduced the marketability of the business due to the increased debt.
Shrank the pool of prospective buyers who could buy the business.
All John could do was ask, “Why?”

The short answer is because the market values current available cash flow over speculative future growth potential. Let me explain.

During the planning meetings for this major investment, John Brown and his advisors forgot to talk about one detail. John Brown wanted to retire. He was so convinced that these investments would catapult the value of his business that he never brought up the fact that he wanted to retire. After all, according to his logic, anyone would be able to see the increased value created by all the new capacity. Unfortunately, his advisors just assumed John was going to run the place until he died, after all, “Why else would he invest all this money?”

Business buyers price businesses based on the future projectable cash flow discounted back into today’s dollars. Unfortunately, the future is not easy to see or predict. For that reason past cash flow tends to be the best indicator (or at least the one people agree on) of future cash flow. When John made this investment he significantly increased his future cash expenditures. Prospective buyers knew the expenses went up, but they were much more skeptical that the sales would grow at 20% for the next five years instead of the historic 10% from the last three years.

When John increased his yearly overhead expenditures $250,000 per year he reduced his business value by about 5 times that amount or $1,250,000. This reduction in cash flow lowered the amount of money available to pay off likely business acquisition debt. It also reduced the pool of buyers because the business now needed to be marketed to the limited pool of buyers would buy based on unproven growth potential.

The moral of the story is to make sure your business succession and exit strategy ties into the rest of your business plans. Human behavior and valuation theory rewards the highest cash flow at the time of sale over speculative growth “potential”. John and his advisors did everything right except realize that John had a short term horizon. A tragic misunderstanding that cost John two years of additional work and $500,000 of lost value when he did sell.

Often, working side-by-side with you for only a few hours, we can make sure your business plan both provides for future growth and creates the maximum exit value possible based on your personal goals and exit horizon.