“I’ll be ready to sell in three or four years, and he’s the only guy I trust to buy it. Problem is, he doesn’t have enough money, what do I do?” Gabe (not his real name) owned an impressive assemblage of businesses, one of which was a hobbyist magazine that served a loyal subscriber base. Gabe had a deep commitment to the magazine’s readership and felt his long-time editor was the right guy to handle the magazine’s future.
“Problem is,” Gabe told me, “if he had a pot to pee in, it’d be a small pot.” That was Gabe’s southern colloquialism for saying the editor didn’t have sufficient capital to buy the business. But Gabe was serious that his editor was the right buyer for the magazine. In fact, Gabe had recently turned down a sizeable offer for the magazine from a wealthy guy who was a loyal reader of the magazine, but Gabe didn’t think the guy’s wealth was indicative of his ability to handle the magazine in the future.
Which brought the conversation back to the editor. “How do we put a deal like this together?” Gabe asked, to which I replied, “This is not hard to do if you can get a good start and don’t mind being paid over a long period of time.” “Hmmm, interesting but confusing, please explain,” Gabe said, so I went on. “We structure a cash flow purchase, which means the business’ cash flow funds the purchase. But this will work only if you are comfortable being paid over a period of time, likely a long period of time.”
Knowing Gabe was quite wealthy, I knew he wouldn’t be overly concerned about how long this deal would take to pay out, but there would be a few other details to work out. A cash flow purchase only works when three things come together. First, the buyer, in this case the editor, has to have some kind of down payment. Second, the down payment sets the foundation for how long the payout will occur. And finally, the seller has to be confident the business will continue to be profitable to fuel the payout.
Sort of like the stars and moons aligning, interesting when it happens but rare.
Here’s an example of how a cash flow purchase works. Let’s say the business is valued at $5 million with an annual free cash flow of $1,000,000. The buyer needs to come up with some amount of money to start the ball rolling and prove he has some skin in the game. So let’s say he can come up with $500,000, or 10% of the total purchase price. At the end of that first year, his 10% equity entitles him to a dividend, which is automatically paid to the seller in exchange for more stock. Based on the assumptions you use about tax and growth rates, a cash flow purchase can take three to ten years.
As noted earlier, this idea only works in a limited number of situations when the owner can afford to be paid over time and the business continues to generate a solid cash flow. Oh, and one other thing, this idea only works when the buyer has the ability to transition from being a great employee to being a capable entrepreneur/owner. And that might be the biggest challenge of all, though that’s another story for another time.
JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The names and fact patterns above have been changed to preserve the parties’ identities.
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