Selling a business is a significant milestone in an entrepreneur’s journey. It can bring financial rewards, opportunities for new ventures, and a chance to realize the fruits of your hard work. However, amidst the complexities of selling a business, one crucial aspect often raises questions: What happens to your cash reserves?
Cash reserves create a tricky conundrum in many business sales. Is cash included? How much cash is included? How it calculated? Is a valuation multiple applied? In this post, we’ll explore the tricky aspect of cash reserves when selling your business and provide valuable insights to help you navigate this critical financial aspect.
I’ll share my personal approach below after we cover some basics!
The Role of Cash Reserves in a Business
Cash reserves are the financial lifeline of any business. They represent the liquid assets a company holds, typically in the form of cash or readily accessible funds in bank accounts. Cash reserves serve several vital purposes:
- Operating Capital: Cash reserves ensure a business has the necessary funds to cover day-to-day operating expenses, such as payroll, rent, and utilities.
- Emergency Funds: They act as a safety net in case of unexpected financial challenges, such as economic downturns or unforeseen expenses.
- Growth and Investment: Cash reserves can be used to fund expansion, invest in new opportunities, or weather market fluctuations.
- Crisis Management: In times of crisis or disruption, cash reserves provide the means to adapt and survive.
Determining the Value of Cash Reserves
During the business valuation process, potential buyers and valuation experts will consider your cash reserves as part of the overall financial picture. Here’s how cash reserves may be factored into the valuation:
1. Adjusted Sale Price
- In some cases, the sale price of your business may be adjusted based on the amount of cash reserves you have on hand.
- Excess cash reserves beyond what is considered necessary for the business’s operations may lead to an increase in the sale price.
2. Cash Flow Considerations
- Cash reserves can influence the perception of your business’s future cash flow potential.
- Buyers may be more attracted to a business with healthy cash reserves as it can provide a buffer against unforeseen challenges.
Negotiating Cash Reserves in the Sale
The negotiation process plays a pivotal role in determining what happens to your cash reserves when selling your business. Consider the following:
1. Allocation of Cash Reserves
- Negotiate the treatment of cash reserves in the sale agreement. Determine whether the buyer will acquire these reserves as part of the transaction or if they will remain with you.
- Explore the possibility of allocating a portion of cash reserves to cover any potential liabilities that may arise after the sale.
2. Escrow Accounts
- In some cases, a portion of the sale proceeds may be placed in an escrow account to cover any contingencies or disputes.
- Discuss the terms and conditions for releasing escrowed funds.
3. Payment Structures
- The payment structure of the sale can also impact your cash reserves. For example, if the sale includes an earn-out arrangement, you may receive payments over time, affecting your immediate cash position.
My Personal Approach to Cash
Here is how I generally approach the cash when working on a deal — I find a simple approach wins. Do keep in mind, there are exceptions but this generally effective and fair in more than 50% of transactions.
I will value business based on a multiple of seller discretionary earning or free cashflow (whichever is more closely aligned with the industry) and then the value of assets that produce a return. As cash isn’t an asset for producing returns in most small businesses, it is not included in the valuation, and subject to 100% distribution to the seller. This results in lower total valuation which increases the marketable audience, and keeps all the cash in the sellers pocket.
Adjustment For Unearned Revenue.
Some businesses may have unearned revenue sitting in their bank account, usually deposits from customers. As nothing has been expensed to earn that, and cash will have to be expensed in the future my the new owner (who is assuming this liability),an adjustment unearned revenue in a reduction to the total price of the business is fair.
Using this logic, if there are accounts receivable the value of them should be adjusted to increase the sale price of the business. Having a high accounts receivable when selling the business and including them in the total selling price is actually favorable to the seller as this effectively capitalizes ordinary income for cash basis takes payers and makes it a capital gain resulting in lower taxes.
Selling your business is a complex and often emotionally charged process. Understanding the fate of your cash reserves is a critical aspect of this journey. Proper preparation, valuation, negotiation, and post-sale planning are essential steps in managing your cash reserves effectively. Remember that each business sale is unique, and the outcome regarding cash reserves will depend on the specific terms of your sale agreement.
As you embark on this journey, seek guidance from financial advisors, legal experts, and business professionals to ensure that your cash reserves are handled in a way that aligns with your financial goals and secures your financial future.