Sizing an acquisition against cash flow instead of the asking price

The asking price is an opinion held by someone who is not going to make the loan payments. The number that matters is what the business can service after you have replaced the seller, paid for the equipment that wears out, and left a margin for the year that goes wrong.

Build that number first. Then compare it to the price. Doing it in the other order means you spend months negotiating a deal that no lender will fund and no buyer should want.

Step one: adjusted cash flow

Start from seller's discretionary earnings or EBITDA, then make two deductions almost every buyer skips.

Step two: what that services

Pick a coverage ratio and solve backwards. At a 1.25 coverage requirement, the maximum annual debt service is 202,000 divided by 1.25, or 161,600 — 13,466.67 a month.

At an illustrative 9 per cent over ten years, a payment of 13,466.67 supports a loan of about 1,063,081.

Add the equity you are actually putting in. At 10 per cent of a 1,450,000 asking price, that is 145,000. The supportable price is roughly 1,208,081.

The asking price is 1,450,000. The gap is 241,919.

That gap is the whole negotiation. There are four ways to close it and you should know which one you are using:

1. Price. The seller comes down.
2. Seller paper. The seller takes part of the price as a note. It only helps if it is on standby, because a note with payments is debt service too.
3. More buyer equity. Every additional dollar of your cash reduces the financed amount one for one.
4. A longer term. Ten years at the illustrative 9 per cent supports 1,063,081; stretching the term raises the supportable debt but also the total interest, and lenders cap term by asset type.

Say the seller agrees to take 270,000 as a note on full standby. The financed amount becomes 1,035,000, the payment 13,110.94, annual debt service 157,331, and coverage lands at 1.28. The deal is now fundable — because a quarter of the price agreed to wait, not because anything about the business changed.

Step three: the sensitivity that decides it

At the ask, the price is 7.18 times adjusted cash flow. At the supportable price, 5.98 times. Both multiples are only as good as the cash flow underneath them, so stress it.

A fall in revenue hits cash flow harder than it hits sales, because the fixed costs do not move. Illustrative only — with a structure carrying 157,331 of annual debt service, a 22 per cent fall in adjusted cash flow takes coverage to exactly 1.00. A 33 per cent fall takes it to 0.86, which means the business does not make its payments and you do, out of savings, until something changes.

Now ask what could produce a 22 per cent fall. One customer leaving. The seller's brother-in-law taking his business elsewhere. A lease renewal at market rent. A key employee following the seller out. If you can name three plausible events of that size, the structure is too tight regardless of what the spreadsheet says on day one.

What this means for how you negotiate

• Put the coverage arithmetic in the letter of intent conversation, not after diligence. "This is what the cash flow services" is a defensible position. "My lender says no" three months later is not.
• Ask for the standby note before you ask for a price cut. Sellers are often more attached to the headline number than to the timing of the money, and standby paper costs them less than they think if the business performs.
• Do not let the working capital question drift. In most asset purchases, receivables and payables stay with the seller and you fund the entire operating cycle from day one. That is a separate number on top of the price, and it is frequently six figures.
• Treat an earnout as debt service in the year it is payable, unless it is structured to be funded by the incremental profit it measures.
• Check the multiple against reality, not against a listing. A price expressed as a multiple of a number nobody has verified is two assumptions stacked on each other.

Before you sign anything

1. Rebuild the seller's cash flow yourself from tax returns and bank statements, not from the broker's recast.
2. Deduct owner replacement and maintenance capital spending, in writing, in your own model.
3. Solve for maximum supportable debt at 1.25 coverage, then at 1.35, and see how much the extra cushion costs in price.
4. Identify the three events that would cut cash flow by a fifth, and ask the seller directly about each.
5. Size the day-one working capital requirement separately and decide who is funding it.
6. Only then make an offer, and make it with the arithmetic attached.

Walking away from a good business at a bad price is a normal outcome. Buying a good business at a price that leaves no coverage is how a profitable company ends up in default in year two while still being a good business.