Cash Flow is complex, and it’s vital for business owners to understand it. The complexity comes from the fact that it is fluid, flows in different directions, speeds, and can go off-course relatively easily. Misunderstanding cash flow often leads to a reactionary relationship with it.
To complicate matters, business owners face cash flow on two fronts: in their business and in their family. Being aware of the interdependency between the two is vital for reaching one’s financial security and goals. When a business owner can see how changes in their business’s cash flow directly impact their family’s lifestyle, it can be the awakening needed to make the necessary changes for an effective succession.
BEI defines a successful transition as one in which a business owner leaves their business on a desired date, for the amount they need, and to the successor of choice. This success is achieved by addressing five critical elements:
- Target Departure Date
- Preliminary Financial Needs Analysis
- Target Successor
- Preliminary Business Valuation
- Future Cash Flow Estimate
It is obvious that cash flow is a factor for the last element. However, understanding your business and personal cash flow is critical for all five elements.
Target Departure Date
Starting with setting the target date, we know that this is likely to change and is heavily dependent on cash flow. The owner could be ready to start the transition right away, while the cash flow of the business and family tells a different story.
It’s not until they have truly defined their cash flow needs that a date can become solidified.
Preliminary Financial Needs Analysis
In doing the preliminary financial analysis, we discover the real need of the business owner during retirement. When you start developing goals, you uncover unrealized cash flow needs. While some desires, such as volunteering, are charitable in nature, often the cost of big-ticket items like travel aren’t considered and can’t be overlooked when determining need.
Frequently, the perks of being a business owner hides their family’s true burn rate, meaning the business owner and their family do not know what the owner’s real paycheck is. Often the owner’s draw or reported salary is not one that fits with their current lifestyle. Whether big things like healthcare or a car, or little items such as cell phones, expenses can really add up quickly.
In the end, the business owner may find that their lifestyle is thousands of dollars more a month than their initial estimate. It’s this interdependence between business and personal cash flow that often is overlooked and causes a misdiagnosis of “The Asset Gap” or the amount the business owner needs to make in the sale of the business.
This misstep can really derail the whole Exit Plan. Providing a business owner with a realistic lifestyle number can give them the confidence and clarity they need to move forward with the plan.
Identifying a Target Successor
When identifying a successor, it’s important to realize that the two parties in the transaction both need to understand their cash flow, especially if it is an internal sale. When passing the torch to a family member or key employee, the current owner is hoping to leave a legacy and have the company carry on for generations to come. To best make this goal a reality, one needs to study how cash flow will change for the business under new ownership, and how owning the business will impact the successor’s personal cash flow.
We know the business cash flow is going to change starting with the elimination of the current owner’s income. Now this may just be redirected, perhaps to the premium on the loan that funded the sale. We need to understand if the business can take on this debt.
Purchasing the company also impacts the successor. If they have the advantage of using the business to cover personal costs now, how does that impact personal cash flow and lifestyle?
On other hand, if the purchase decreases income even for a short period, is that offset by the potential future gains? If the successor has a firm grasp of their own cash flow, these questions can easily be answered and any concerns they may have are easily overcome.
Preliminary Business Valuation
In calculating a preliminary valuation, it could be discovered that the profit from sale of the company will not fill the gap that exists for the owner. It is at this point that business decisions must be made. Will the owner work longer, change their lifestyle to save more, or try to build the company to increase its valuation? If working longer is not an option, then you need to look at potential cash flow changes at the business or personal level.
Being able to look at what they can change such as adjusting the cost of goods sold, or determining how they can reinvest to grow the business, or even how a revised owner’s paycheck will impact both the business and their lifestyle, is essential to helping the owners make the decisions necessary to have a successful transition.
Future Cash Flow Estimate
Going hand in hand with the business valuation, estimating the future cash flow needs are also important. A professionally prepared cash flow forecast estimate helps advisors and business owners assess the likelihood of success of various exit paths. In any transition, the cash flow is used as a measure of the value of the purchase and establishes financial credibility for the Exit Plan.
It’s the forward-looking planning in the Exit Planning Process that will give your client the confidence in their Exit Plan and empower them to make the best decision for their financial future.
Conclusion
Coming full circle, we see how ensuring a proper understanding of both business and personal cash flow for the current owner and potential successor during the entire succession process provides confidence and clarity to the Exit Plan. Working to improve cash flow and staying on top of cash flow management while working on the Exit Plan gives your client one less thing to keep them up at night.
We will be hosting an informational webinar, Q & A style, on October 26, 2022 at 1pm ET on the topic of cash flow as it relates to Exit Planning. Save your spot today: Live Q&A: Cash Flow in an Exit Plan (exitplanning.com)
