Selling a Small Business
By: Clay Brock
Recently, we’ve come across several companies for sale with substantial fixed assets – generally in the form of manufacturing equipment. A large asset base is normally a positive in the sale of a small business because it provides a buyer with the collateral necessary to obtain debt financing from a bank. Generally, banks feel more confident that they can get their money back if things go poorly and thus are more willing to lend money to a buyer (this is asset based lending 101).
A little aside on asset valuations is required here: replacement value is what it would cost to replace the assets in hand. The appraised fair market value (FMV) of assets is often a better proxy for true asset value because FMV generally reflects the earning potential of the assets. Also, banks do not lend on replacement value but rather orderly liquidation value (a reduction to FMV).
In the particular cases we were evaluating, each company’s large fixed asset base actually prevented a transaction from occurring. Why? Because these businesses did not generate enough free cash flow to support a purchase price equal to the replacement value of assets. Some sellers find it difficult to understand why their company is not worth at least the replacement value of assets.
It comes down to the old saying, cash is king…free cash flow in this case. There is a limit to the amount of debt a company can support and that limit is based on free cash flow, not the size of the asset base. In a buyout involving debt, a company must generate enough consistent free cash flow to support its future debt payments, taxes and capital investment needs (plus a cushion to protect the business in a downside case). Thus, there’s only so much debt we can, or will, put on a company. The rest of the purchase price must be funded by equity (or by the seller in the form of an earn-out, etc.). More equity equals less expected investment return, all other things being equal.
In these recent cases where the companies’ assets were very large __relative to their free cash flows, we were not able to meet the sellers’ valuation expectations. The amount of debt was fixed by the cash flow, and the amount of equity required to pay the replacement value of assets resulted in equity returns that were too low to meet our investment needs.