As many of you know, Red Rocket has been looking for a businesses to buy. We have previously written about all the challenges that come with buy-side mergers and acquisitions work. But, there is a new wrinkle we have been running into, that is worth talking about. Most businesses we have looked at were managed to maximize net profit, which is typically a good thing. But, when trying to attract an acquirer, they really should have been managed to maximize net cash flow. At the end of the day, that is really what matters most to investors–getting visibility into a near term return of their invested capital that hopefully can pay back in 12-18 months, not four to five years. Let me explain further.
DEFINING THE DIFFERENCE BETWEEN NET PROFIT AND NET CASH FLOW
Net profit is a pretty straight forward calculation; it takes all the revenues of the business collected from customers in a time period and subtracts all the expenses of the business in that same period. Those expenses include things like the cost of goods sold and all the selling, general and administrative costs of the business (e.g., marketing, payroll, home office). Net profit is an income statement output.
Net cash flow is a cash flow statement output. It starts with the net profit calculated above and then adds back non-cash items like depreciation and amortization, and then subtracts other longer term investments made in the business, like build-up of inventory for future months’ sales, research and development costs made for future product offerings and other capital expenditures (e.g., for new equipment or capitalized software investments).
WHY MANAGING TO CASH FLOW MATTERS
Let’s say we had a business with $5 million in revenues generating $800 thousand in profit before taxes and $1 million in earnings before interest, taxes depreciation and amortization (EBITDA) when you add back $200 thousand of non-cash items, like depreciation. Since most businesses are valued on a multiple of EBITDA, this business may be worth four times the cash flow or $3.2 million to a potential acquirer, depending on how fast it is growing.
However, potential buyer of that business then starts to peel back the layers of the onion on the cash flow statement. From this, he or she uncovers the business is making $1 million of off-income statement investments to support their growth into things like building up inventory for future months and R&D investments into future products. That takes the net cash flow of the business down to zero.
So, with most acquirers looking for businesses with high net cash flow, with which to attract bank financing and to have funds from operations with which to pay down their loan and interest over time, this presents a major challenge for the buyer. Instead of getting a business that they thought was generating a lot of profits (which is valuable to them), they are getting a business that is cash flow neutral (which is not that valuable to them, given the nature of their business). What worked well for the entrepreneur in growing their revenues at the expense of short term distributions, does not work well for most private equity investors or acquirers of your business.
WHEN THIS IS NOT THE CASE
Obviously, if you are not trying to sell your business, making potential investors or acquirers happy doesn’t matter. You can do what you like in those cases. The reason most businesses don’t care about driving huge positive cash flow is because they are more focused on re-investing all cash flow into the company. This helps propel the business to new heights in future years (not caring about the impact to profits or cash flow in the current year). Amazon is a great example of a company that has had major success with a strategy like this, although it ruffled the feathers of many of their early investors as a public company, since it was counter to the norm of maximizing near term profits.
We were studying the potential acquisition of an ecommerce seller of branded shoes. They were showing very impressive revenue growth from $5 million to $10 million to $15 million over a three year period, and net profits were growing right along with it, from $1 million to $2 million to $3 million. That would attract the excitement of most any investor or buyer.
Until we looked at the cash flow statement in more detail, we learned they needed to invest the full $3 million of profit into their future inventory investment required to support the next year’s expected revenues of $20 million. With a 50 percent cost of sales ($10 million) and three times the inventory turnover ratio ($3.3 million of inventory needed for next four months, they needed every penny of the prior year profits and more to fund their growth.
So yes, if the plan was to shut off the growth at $15 million, and milk the $3 million of profits out of the business in perpetuity, that would appeal to certain buyers. But, if the plan was to grow a $15 million business into a $50 million business, all while distributing a portion of profits to the shareholders or the lenders along the way, this business wouldn’t attract anyone.
WHAT THIS MEANS TO YOU
Yes, profits are important and should be maximized. Especially since they are the root driver of EBITDA which is relied on heavily in valuing companies. But if at the same time, you are not being sensitive to maximizing cash flow during growth periods of your business, you are going to have a hard time attracting new investors, lenders or acquirers. At the end of the day, there has to be enough cash left to distribute out to the investment partners in a business (e.g., banks, private equity firms), along the way, in order to get their upfront attention. So plan accordingly.