Many owners focus on the overall valuation figure when selling a business, hoping for the highest possible exit. However, it’s crucial to remember that not all promised amounts are created equal.
The Story of the $10 Million Pizza Shop
To illustrate the importance of cash at closing, consider this story:
A buyer tells a pizza shop owner, “I’ll gladly pay you $10 million for your pizza shop. $10 per year for 1 million years. There’s your $10 million offer.“
On paper, this is a $10 million offer. In reality, receiving $10 per year for 1 million years is practically worthless. The owner won’t see most of this money, and its value erodes significantly over time. This example shows how promised future payments can be misleading and unreliable.
The true value lies in the receipt of cash at closing. Unlike earnouts and other post-closing payments, cash at closing offers immediate liquidity and significantly reduces the seller’s risk. In this article, we delve into why cash at closing should be the primary focus for any business owner looking to exit, highlighting the pitfalls of relying on future promises and the importance of securing your financial future upfront.
Understanding Business Valuation
Business valuation is the process of determining the economic value of a company. This is crucial when selling a business, as it helps buyers and sellers understand what the business is worth. There are several methods to value a business, including looking at the company’s cash flow (EBITDA) and revenues or using more complex financial models like discounted cash flow.
The Illusion of Total Promised Amount
When selling a business, the deal often includes upfront cash, earnouts, and seller notes. Earnouts are future payments based on the business’s performance after the sale. Seller notes are loans the seller provides to the buyer to be paid back over time. While these promises can look appealing, they come with significant risks.
Earnouts depend on the business hitting certain future targets. Those payments might never materialize if the business doesn’t perform as expected. Changes in management, market conditions, or operational issues can all affect performance. Seller notes also carry risk, as there’s always a chance the buyer won’t be able to repay the loan.
The Importance of Cash at Closing
Cash at closing is the amount the seller receives immediately when the sale is finalized. This is the safest part of the deal for the seller. Here’s why cash at closing is so important:
- Immediate Liquidity: You get the money immediately and can use it immediately without waiting for future payments.
- Reduced Risk: You’re not relying on the business’s future performance, which can be unpredictable.
- No Post-Closing Obligations: Once the deal is done, you’re free from the business and any future complications or disputes.
Risks of Earnouts
Earnouts are future payments that depend on the business achieving specific goals. While they can boost the total sale price, they come with many risks:
- Uncertainty: Future business performance is never guaranteed. Market shifts, competition, or internal problems can affect results.
- Disputes: If targets are not clearly defined, it can lead to disagreements and even lawsuits.
- Dependency: Earnouts often require the seller to stay involved in the business, which can be stressful and time-consuming.
For example, if a company is sold with a promise of an additional $1 million if it hits certain revenue targets, but then a new competitor enters the market, making those targets hard to reach, that $1 million may never be paid.
Cash at Closing: Best Practices for Sellers
To ensure you get the most secure and reliable return from selling your business, consider these tips:
- Negotiate for More Cash Upfront: Focus on getting a higher percentage of the sale price at closing. This reduces your reliance on future performance.
- Set Realistic Expectations: Understand your business worth today, and don’t overestimate potential earnouts based on unlikely future performance.
- Get Professional Advice: Work with experienced brokers, attorneys, and financial advisors to structure the deal in your favor.
Conclusion
When selling your business, remember that cash at closing is king. It offers immediate financial security and reduces your exposure to future risks. While earnouts and seller notes can add to the total sale price, they have significant uncertainties. By prioritizing cash at closing, you can ensure a smoother transition and a more secure financial future. Focus on what you can count on today, not what might come tomorrow, based on contingencies outside your direct control.
