What I’m about to describe is difficult for some people to understand. Recently, I completely failed to convey this concept to an experienced professional accountant.
The fact is, nobody can sell your cash well.
What I mean is this: if you’re thinking about selling your company, I feel strongly that it’s desirable to strip out the cash that’s not absolutely necessary before starting the exit valuation negotiation with prospective buyers.
Even better, the company should have just the right amount of debt, probably in the form of a bank operating loan, to smooth out the peaks and valleys in working capital.
While I can’t prove this mathematically, I feel strongly enough to recommend that owners strip out the cash before the exit, even if it means incurring some tax.
The simple reason is that buyers will pay less than a dollar for a dollar’s worth of cash. (This made no sense at all to the professional accountant that I tried to explain this to recently.)
It may help to imagine two scenarios, where companies with exactly the same income statements have balance sheets which differ by $1 million in excess cash. If you offered each of these companies to 100 buyers, the average price for the company with the cash would be less than $1 million more than the company without the cash.
This is the result of the imperfect science of company valuation plus the peculiarities of human psychology.
Valuation based on multiples
Almost everyone will think, at least in part, of company valuation based on revenue or profitability multiples. Buyers are used to thinking that certain types of businesses are worth four to six times EBITDA. Or that certain types of companies that are growing at 50 to 100% per year are worth three to four times revenue. These multiples evolve from comparative valuations.
When people use multiples for valuation, they often switch back and forth between the current year and the next projected year. Depending on the company growth rate, that can result in a very big difference in the valuation, which illustrates how imprecise valuation calculations are.
In my direct experience, almost nobody will take into consideration the additional value of having cash on the balance sheet when doing a valuation based on comparative multiples.
Cash makes the price higher
Having excess cash compared to working capital requirements makes a company more expensive. Sellers will expect to get the same multiple described above, plus a fair value for their cash. From the buyer’s perspective, they are being asked to pay what they think is a fair price plus an additional amount. (At this point the professional accountant thought I had lost my mind.)
But the reason this is an impediment is that the people who buy companies have to go through an internal consensus building process to get to an approval. Some of the people they need to ‘bring onside’ will not take the time to appreciate that there is excess cash on the balance sheet. I know this seems difficult to believe, and you’d expect that even people in a large company would care about whether there was an extra million dollars or not, but on average they care less than the actual value of the cash.
The higher the total price, regardless of how much cash is on the balance sheet, the more difficult it is to get the valuation approved. This difficulty creates a suppressive effect on the total valuation (i.e. the value of the business + the cash).
Most buyers have too much cash
It’s a fascinating and difficult-to-appreciate psychological fact that most buyers have so much cash that it’s a problem. For them, having cash come along with an acquisition really isn’t any advantage. Cash is the least of their concerns.
Working capital efficiency
Perhaps the most logical reason that nobody can get full price for excess cash is that buyers will assume that the previous shareholders left that cash in the company because it’s required to operate the business. What this means is that the buyers will discount the value of the cash because they consider it necessary to generate profit. In their minds they’re paying for the stream of future profits, and they don’t really spend a lot of time thinking about what assets are required to generate those returns.
The more working capital that’s required, the more they’re going to reduce the value of the business. In other words, the most valuable company is one that can generate a given profitability on the smallest amount of working capital. In other words, that company is a more efficient generator of profits – and is therefore more valuable.
Closing working capital
An experienced M&A Advisor will always negotiate the amount of working capital at closing. This is one of several dozen tactics to maximize the value received by the sellers. It can also be a powerful tool in increasing the probability of closing.
The optimum amount of working capital at closing is usually zero, or perhaps a modest amount such as $250,000 or $500,000.
The idea situation when the transaction closes is not to have any significant amount of working capital above that specified at closing. The reason is that if the company has excess working capital, it will require another cheque to be issued by the buyer several months after closing. This is always problematic because in the post-closing transition it will take the buyers a number of months to stabilize their accounting systems.
Every time we’ve had to help buyers and sellers through a post-closing working capital adjustment it’s been arduous. The need to re-engage also occurs at a time when the buyer and seller are both looking forward to not working on the transaction, but instead working on the newly acquired business or their recently expanded investment portfolio.
Nobody can say how much any of these factors affects any individual’s perception of value. But there’s no question in my mind that, taken together, the important conclusion to be drawn is that the value of excess cash in a company is worth more to the seller than to the buyer.
For these reasons, it’s usually worth the time at the early stages of the exit process to investigate the options for stripping out the cash and possibly even putting in place enough debt to provide the optimum amount of working capital.