Many companies want to be acquirers but they may not strategize about the perfect seller nor model out how leveraging the purchase price with some debt will change the cash flow. In most cases, buyers talk about the multiples of EBITDA they are willing to pay for the right candidate. However, we would argue that the “right” candidate is the one that will maximize the buyer’s return on cash invested.
Cash flow is important in business as well as to your bank and/or investors. If you are evaluating two companies that each create annual cash flows of $100,000 and one is asking for three times EBITDA (Company A), while the other is seven times EBITDA (Company B), you may be tempted to not even consider the seven times company.
But would your opinion change if you learned that Company B has $800k of valid accounts receivable, while Company A only has $200k? If your bank is willing to lend 80 percent of accounts receivable at 5 percent, your net purchase price for Company B will only be $60,000 (7 times $100,000 – ($800,000*80 percent)) and your expected cash flow will be $64,000 per year ($100,000 less $720,000*5 percent).
On the other hand, Company A’s net purchase price will be $140,000 (3 times $100,000 less $200,000*80 percent) and its adjusted cash flow will be $92,000 ($100,000 less $160,000*5 percent). Suddenly, the seven times EBITDA company doesn’t look so bad.
Another important consideration for acquirers is the potential tax savings opportunities some sellers may be able to provide. For instance, we still see some accrual basis taxpayers in professional service companies, which can present large tax savings to some buyers. If you own a professional services company that is a cash basis taxpayer, you may be able to purchase that accrual basis taxpayer, convert it to the cash basis, and recognize the tax benefit – all in year one. This requires careful tax planning and there are stringent rules in order to qualify to switch the buyer to the cash basis, but the tax savings can be considerable and may pay a significant part of the purchase price.
Things are not always what they seem at first glance. Leveraging and tax considerations are two key elements to consider when evaluating potential target companies.