How do you value a cash flow negative business?

Question

Looking a buying a non-performing business of an art workshop franchise. Being a franchise, can't share any of the numbers (signed an NDA).

Labor costs are way too high, and the owner is barely involved. There's always the risk of brick and mortar given the "pandemic" but what do you guys think?

How would you value a cash flow negative business, knowing you could turn it around with proper management?

Any steps specifically to help mitigate risk or atleast plan for it better?

Emotionally want this business, but understand the numbers need to match. Having a hard time converting real estate knowledge into business knowledge.

Thanks in advance!

Joe Villeneuve · Answer

When you start letting emotions enter your decision making, you are setting yourself up for disaster,  Why in the world would you even be considering this?

Joe Villeneuve · Answer

Sure things are like that.  I bet all those people that invested in companies, "just like Amazon" (at least that's what they were thinking at the time), that you've never heard of because they tanked, said the same thing.  Right before they lost all their money.

Account Closed · Answer

Why do you need the franchise? Its not like its a McDonalds. What is stopping you from starting your own similar business and not sharing the profits? Often the franchise fees eat up most of the profit (and comes off the top line) and also imposes restrictions like telling you how much you have to spend on marketing. If your wife knows the business just open another one and kick this one out of business!!

Joe Splitrock · Answer

@Lawrence Gillett two comments...

1. A business should not require the owners to be active to be profitable. If that is required, you are buying a job, not a business. Maybe it is more profitable if you are active, but it shouldn't be required. An owners efforts should be on growing a business not working in a business.

2. A business is valued on current performance, not valued on how it will perform when properly managed. It is like when someone is selling a property and the owner advertises "opportunity to raise rents". If there was an opportunity, they would have raised rents. I am not saying you can't make the business more profitable. I am just saying the value is based on current profitability.

Still, even a negative cash flow business has value. Franchise rights, equipment, inventory, customer base and location all have value. I would look at the cost to start a business like this from scratch for comparison. Most franchises have startup cost estimates, so that will tell you what he has invested into the business. I am not saying you should pay the same as startup. The owner is burnt out and we are in a pandemic that is hurting store front businesses. You should be getting a discount because of this.

A poorly run business is not worth as much as a well run business. The previous comparison to Amazon is horrible. Amazon reinvested cash for growth, so their lack of profits are due to a growth plan. Based on what you are saying, the current owner has excess costs and a poor growth strategy.

Final thought, it is ok to be passionate about a business, but make sure the numbers work. Passion can cloud judgement.

James E. · Answer

@Lawrence Gillett Simple answer is that a company is worth the expected value of future cash flows. Finance 101 would tell you to do a discounted cash flow model and contrast with industry comparables for similar transactions (as @Daniel McNulty mentioned above, this one would likely be a top-line revenue comp).

The better answer is that you should consult with professionals on this. You could hire a business broker to help with the transaction, and specialized CPA's to perform a book and market valuation. This is a big decision - don't put yourself at risk by being penny smart / dollar stupid. If you go this route, one thing that has helped me tremendously is to record your meetings - you'll always have some things go over your head and you can reference back to your conversations this way and look up anything confusing or contradictory.

Joe Villeneuve · Answer

First, don't mistake passion about something, and emotional decision making, as the same thing.  All squares are rectangles, but not all rectangles are squares.

Second, when I said "why are you considering this", I was asking why would you consider investing in a deal that you already new was losing money?  The idea that you can fix it, is an emotional decision.

Ryan Landis · Answer

@Lawrence Gillett I am not a business broker, but as others have mentioned you usually want to look at revenue (EBITDA/etc. can start getting involved with bigger transactions but just use revenue). You can see what comps are possibly selling for based on that revenue stream (might be 1x or 3x - just depends).

I will say that a value add business is probably a bit more time consuming than a value add real estate project (just my 2 cents) but I don't think value is only based on what a property (or business) is currently doing. You as a buyer need to understand potential. I get that most properties are bought based on cash flow, but there have been so many transactions that I have been involved in where the prices we paid, if based on cash flow alone, would have never gotten the deal done. If there is a sweet upside that you can bring to the table, and just consider that and assign it a probability. Not saying others will necessarily pay that price, but if you can pull it off then you are still going to end up better than not getting it.

Take my thoughts here with a grain of salt as I have only seriously considered maybe buying 1 or two businesses and most of my experience is in real estate.

Storm S. · Answer

@Lawrence Gillett you value a negative cash flowing business by looking at revenue growth rates and price to revenue multiples or you do a discounted cash flow analysis of the business.

Brett White · Answer

Warren buffet said Invest in cash flow.

Not passion

Goodluck...

Lawrence Gillett · Answer

@Jonathan R McLaughlin well the goal is profitable business -> buy the building or move in local area and purchase a building to become our own tennants.

How do you value a cash flow negative business?

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