small business Archives

Cash Flow Normalization

March 3, 2025February 20, 2025 by John F. Dini

Cash flow normalization is done with the intention of identifying Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) or Seller’s Discretionary Earnings (SDE). These differing measures are not interchangeable, but are used by different classes of buyers for different categories of acquisition.

Free cash flow is an important measure when calculating the value and price for any business. It is the amount theoretically available for servicing acquisition debt, working capital, return on investment for any cash outlay in the acquisition, and future expansion.

Cash Flow Measures

EBITDA establishes free cash flow as a measurement for most mid-market businesses. It evens out the differences in earnings caused by various tax jurisdictions. In the United States, there is federal income tax at the corporate level, but many states have additional income taxes, and in some cases, even smaller jurisdictions like cities may have their own income tax. These obviously impact the profitability of a company and could distort a buyer’s impression of its profitability.
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EBITDA calculations do not include the owner’s earnings, since the companies being examined are more likely to be acquired by investors who would replace the owner with a management executive.

SDE is the measurement used to illustrate the sum total of financial benefits available to the owner-operator of a business. It assumes that the owner is running the company on a day-to-day basis. SDE encompasses not only salary, bonuses, and distributions, but includes insurance and other benefits such as a company-paid vehicle.

A simple way to put it is that EBITDA is the cash flow available for a return on investment. SDE is the cash flow available for a return on the owner’s labor.

Making Adjustments

In the SDE calculations, there are two places where there is often an adjustment of expenses to market. The first is for a family member employed in the business or partners who intend to leave simultaneously with the principal owner.

In many instances, family members are paid according to their needs or the needs of the business instead of at a market rate for the position. With family members who are “underpaid” adjusting to the market rate will have the effect of reducing the cash flow available in the business. This reflects the fact that the family member or partner will have to be replaced by someone who is unlikely to work for a below-market salary.

The opposite is of course true for family members or partners who are overpaid. Reducing their compensation to a fair market rate will add to the discretionary cash flow of the business.

A second area of adjustment is when the owner of the company also owns the real estate that the company operates in. Again, the rents paid on the real estate often reflect the owner’s objectives more than they do the practical reality of the local real estate market.
A company that is underpaying rent is having its bottom line shored up by the reduced income to the real estate entity.

Overpayment of rent requires the owner to make a decision. If they expect the same rent from a new tenant, the profitability of the business as presented to a prospective buyer will be lower. Considering that most transactions involve a multiple of cash flows, you can usually point out to the owner that trying to maintain a higher rent is not in their interest as the seller of the company. Adjusting the rent to a market rate increases the cash flow of the company and presumably the basis for an evaluation multiple.

Which Cash Flow is “Right?

The decision of whether to use EBITDA or SDE when calculating cash flow is dependent largely on the size of the client’s business. If the company has cash flow in excess of $1 million annually or is large enough to be a likely target for professional buyers, EBITDA is the appropriate measurement for cash flow.

If the company is going to be purchased by family members, employees, or another entrepreneur and has a cash flow of less than $700,000, SDE is almost always a more appropriate measurement.

Which cash flow is used is a situational decision and may change if different classes of buyers are being engaged.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Purpose – Life After the Sale Part 3

January 3, 2025 by John F. Dini

The third component of life after the sale is Purpose – “Having as one’s intention or objective.”

Many exit planning advisors discuss the three legs of the exit planning stool – business readiness, financial readiness, and personal readiness. In our previous two articles, we focused on two of the “big three” components of a successful life after the sale, activity and identity. The third is purpose.

So many advisors point to the 75% of former owners who “profoundly regret” their transition, and say it’s because they didn’t make enough money. To quote Mr. Bernstein in the great film Citizen Kane, “Well, it’s no trick to make a lot of money…if all you want is to make a lot of money.”

I’ve interviewed hundreds of business founders. When asked why they started their companies, by far the most common answers are about providing for their families and having control of their future. Only a very small percentage say “I wanted to make a lot of money.”

Decades of Purpose

So what kept them working long hours and pushing the envelope after they had reached primary, secondary, and even tertiary financial goals? Sure, non-owners may chalk it up to greed, but Maslov’s hierarchy of needs drifts away from material rewards after the first two levels. Belonging, Self-Esteem and Self-Actualization may all have a financial component, but money isn’t the driver.

For most owners, the driving motivation is this thing they’ve built. The company has a life of its own, but it’s a life they bestowed. They talk about the business’s growing pains and maturity. Owners are acutely aware of the multiplier effect the success of the company has on employees and their families. In a few cases, that multiplier extends to entire towns.

That’s the purpose. To nurture and expand. In so many cases every process in the business was the founder’s creation. He or she picked out the furniture and designed the first logo. This aggregation of people breathes and succeeds on what the owner built.

That’s why so many owners still put in 50 or more hours a week, long after there is any real need for their presence. This thing they created is their purpose.

Life After the Sale

Unsurprisingly, so many owners find that 36 holes of golf each week, or 54, or 72, still isn’t enough to feel fulfilled. You can get incrementally better, but it doesn’t really affect anyone but you. Building a beautiful table or catching a trophy fish brings pride and some sense of accomplishment. Still, it never matches the feeling of creating something that impacts dozens, scores, or hundreds of other human beings.

That’s why we focus on purpose as the third leg of the personal vision. In the vast majority of cases, it involves impacting other people. Any owner spent a career learning how to teach and lead. Keeping those skills fresh and growing is a substantial part of the road to satisfaction.

Purpose in your life after the sale may involve church or a community service organization. It could be serving on a Board of Directors or consulting for other business owners. It might be writing or speaking. Purpose doesn’t require a 50-hour week, but it does require some level of commitment, and the ability to affect the lives of others.

Private Equity and Privately Held Businesses

October 28, 2024 by John F. Dini

Depending on who you are talking to, Private Equity is either the Great Satan or the savior of small and mid-market companies in the United States. The stories depend a lot on the personal experience of the speakers.

Once a vehicle for high-risk investment plays in corporate takeovers (see Bryan Burrough’s Barbarians at the Gate,) Private Equity has morphed into tranches where specialists seek opportunities in everything from a Main Street entrepreneurship to multi-billion-dollar entities.

What is Private Equity?

The term itself is relatively generic. According to Pitchbook, there are currently 17,000 Private Equity Groups (or PEGs) operating in the US. The accepted business model for our purposes is a limited partnership that raises money to invest in closely held companies. The purpose is plain. Well-run private businesses typically produce a better return on investment than publicly traded entities.

The current Price to Earnings (or PE – just to be a little more confusing) ratio of the S&P 500 is about 27.5. This is after a long bull market has raised stock prices considerably. The ratio is up 11.5% in the last year. That means the average stock currently returns 3.6% profit on its price. Of course, the profits are not usually distributed to the shareholders in their entirety.

Compare that to the 18% to 25% return many PEGs promise their investors. It’s easy to see why they are a favorite of high net worth individuals, hedge funds and family offices. As the Private Equity industry has matured and diversified, they have even drawn investment from the usually more conservative government and union pension funds.

Private Equity Types

Among those 17,000 PEGs the types range from those who have billions in “dry powder” (investable capital,) to some who claim to know of investors who would probably put money into a good deal if asked. Of course, which type of PEG you are dealing with is important information for an owner considering an offer.

The “typical” PEG as most people know it has a fund for acquisitions. It may be their first, or it may be the latest of many funds they’ve raised. This fund invests in privately held businesses. Traditionally PEGs in the middle market space would only consider companies with a free cash flow of $1,000,000 or greater. That left a plethora of smaller businesses out of the game.

For a dozen years I’ve been writing about the pending flood of exiting Boomers faced with a lack of willing and able buyers. I should have known better. Business abhors a vacuum.

Searchfunders

Faced with an overabundance of sellers and a dearth of capable buyers, Private Equity spawned a new model to take advantage of the market, the Searchfunders. These are typically younger individuals, many of whom graduated from one of the “EBA” (Entrepreneurship By Acquisition) programs now offered by almost two dozen business schools.

These programs teach would-be entrepreneurs how to seek out capital, structure deals, and conduct due diligence. Some Searchfunders are “funded”, meaning they have investors putting up a stipend for their expenses. Others are “self-funded.” They find a deal, and then negotiate with investment funds to back them financially.

Both PEGs and Searchfunders seek “platform” companies, those that have experienced management or sufficiently strong operational systems to absorb “add-on” or “tuck-in” acquisitions. The costs of a transaction have bumped many seasoned PEGs into $2,000,000 and up as a cash flow requirement. Searchfunders have happily moved into the $500,000 to $2,000,000 market.

In the next article we’ll discuss how PEGs can promise returns that are far beyond the profitability of the businesses they buy.

Business Continuity Planning

December 13, 2024July 15, 2024 by Michael Jones

A number of years ago, I worked for a financial advisory firm that was affiliated with a broker-dealer (b-d) network of a few hundred businesses throughout the country. Each year, the b-d would take it’s best firm owner customers and their spouses on a fully paid trip. This particular year, it was to Hawaii. Unfortunately, during a scuba diving excursion, one of the owners suffered a heart attack and died.

On top of the shock his family and employees were experiencing, it quickly came to light that he did not have a continuity plan in place. As a result, his family, during their time of mourning, had to scramble to not only keep the firm going day-to-day, but also decide on a longer term solution. As emotionally difficult as the situation was, it also had serious financial implications. Most small business owners have anywhere from 40% to 80% of their family wealth tied up in their business, and this situation was no different.

Luckily for the family, the b-d was a huge help. They provided additional services and technical support to help keep the business operating and even assisted with finding a buyer. While the company wound up being sold at a discount, it was a much better outcome than a fire sale, or worse yet, having the business dissolve.

In this case, the firm had a great relationship with a critical supplier, who was willing and able to step in and help during a crisis. Unfortunately, most small businesses who haven’t adequately planned aren’t so lucky.

What is a Business Continuity Plan?

As the name implies, a business continuity plan is a document that contains everything needed to successfully preserve the company’s value in the event of an owner’s death or incapacitation. There are 2 parts of a good plan. The first is the information that the family and employees need to keep the business going over the short term. The other is a longer-term strategy for the company in the event that the owner will be permanently absent.

A solid plan requires time and effort but is definitely something owners can do on their own. However, if you’d like assistance, there are business and exit planning consultants available to help. Let’s look at what’s included in a plan.

The Emergency Kit

This is where your family and key employees will find the critically important information that’s needed for running daily business operations over the short term. It would include such items as:

Bank account information
Insurance policy information
Points of contact for key business advisors – CPA, Banker, Attorney, Insurance Agent, etc
Lists of key suppliers and customers
Passwords
Information about trade secrets, patents, and other intellectual property
Who has short-term decision making authority

This is just a start. Every business is unique and the emergency kit should include everything needed to run the business as efficiently as possible in the days and weeks immediately following your absence. If the document is complete, your family and key employees should be able to find the answers to the following questions:

1. What do you, as the owner, do on a daily basis in the company?
2. What information do you have that others would need to know about in order to perform these tasks?

Once you think you have everything covered, have your spouse and key employees to review it. They will probably come up with some additional items that need to be addressed.

Long-Term Strategy

This is the portion of the plan that spells out your intentions for the company if you are expected to be incapacitated indefinitely or have died. This may or may not be the exit plan you currently have in mind. For example, if your current goal is to one day pass the business along to your children, but they are still in high school or college, an alternate plan is needed.

In some cases, this strategy could be similar to what you had envisioned if nothing had ever happened. However, additional contingencies may need to be put in place to help ensure its success. Let’s say your plan was to sell the business to your key employees several years from now. If the timetable was accelerated would this plan still work? If not, why not? Could these obstacles be overcome? If so, how?

A common reason I hear from owners planning an employee sale is their lieutenants aren’t quite ready to take over. One solution to this could be to have a ‘just in case’ arrangement with an outside advisor you have already vetted. That way, your employess will know who you want to come in to help manage the business and finish their training.

If you already have a contingency plan in place, congratulations, you’re ahead of the game. Now, when was the last time it was reviewed and updated? If it includes a buy-sell agreement, that should be reviewed on a regular basis as well. For instance, does the buyout amount reflect the company’s current market value? If the buyout is to be financed, is the financing still adequate? A large percentage of buy-sell agreements use life insurance to provide at least part of the buyout funds. If yours does, when was the policy last reviewed by an insurance professional?

If you died yesterday…

What would be going on at your company today? Do your loved ones and key employees have a good answer to this question? If not, then putting a business continuity plan in place will be time well spent.

“Work From Anywhere” Comes Full Circle

April 26, 2023March 15, 2023 by John F. Dini

Work from anywhere has been a necessity, an epithet, an obstacle, and an opportunity over the last 3 years. To paraphrase Aristotle’s axiom about Nature (“Horror Vacui”), business abhors a vacuum. Where one occurs, it is quickly filled.

Work from anywhere started as a COVID-induced necessity. During the lockdowns of 2020-2021 (and longer in some places) we all had a crash course in video calling, VPNs, and virtual meetings.

Employees quickly expanded the definition of anywhere. They tired of shunting the children off to a bedroom during conference calls, or using office-like backdrops to hide their kitchen cabinets. Soon they began changing their backgrounds to something more aspirational, like a mountain cabin or a scenic lake.

From there it wasn’t much of a leap to make the mental shift from a make-believe environment to a physical one. Pretty soon employees were calling in from real mountain cabins. In many cases, they shifted to someplace where the cost of living was much lower than in their former metropolitan workspace.

Work from Anywhere as an epithet and an obstacle

As employees moved further afield from their office environment, bosses began to sound off. “We aren’t going to pay Los Angeles wages to someone who has a Boise cost of living,” was a commonly heard complaint. Most put up with it because qualified help was getting harder to find. Hiring remotely was too hard a new skill to master.

The complaints of employers grew louder as they began to ask employees to return to their former location of working activity. They made arguments about deteriorating corporate culture or a lack of mentoring opportunities.

At the same time, stories surfaced about workers who were getting full-time paychecks from multiple employers, or who were “quiet quitting” by doing as little as possible. The “Great Resignation” forced many organizations to put up with it. If you wanted to keep employees, you needed to accommodate their demands.

Then the work-from-anywhere poaching started. If an employee could do the job from a thousand miles away, why not just hire people from a thousand miles away? Now recruiters could dangle Los Angeles wages at candidates from Boise. Many employers saw work from anywhere as a curse costing them their best talent.

Work from Anywhere as an Opportunity

But as I said at the outset, business abhors a vacuum. Every action has a reaction. When the job can be done from anywhere, does that mean anywhere?

If the higher cost of living centers can fill their needs by hiring people who are accustomed to earning less, why shouldn’t employers look at those candidates before the local talent? The Internet allows almost-instant communication across countries, what about across oceans?

In the last few months, I’ve worked with employers who are hiring accountants in India, staffing recruiters in the Philippines, programmers in Argentina, support techs in Colombia, and screening nurses in Nicaragua. None of these employers are multinationals. Each one fits the SBA’s definition of a small business.

Their new employees are educated, English speaking, have the same hours as the employer, and are thrilled for the opportunity. Some are hired directly through a local placement agency. Others work for an organization in their home country that makes them exclusive to the client and promises to replace them if needed.

Most of the wages appear to be about 50% more than the same job would pay in the country of residence, and roughly half of what the position in the U.S. would cost.

Business has once again filled a vacuum. I wonder what is next?

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.