Warren Buffett started out as a value investor. His goal was to spot undervalued companies. Think “buy low.”
Then Charlie Munger, his business partner at Berkshire Hathaway, persuaded Buffett that paying a premium for a company sometimes made sense, especially when growing the target business would require little in the way of additional capital. Think “buy high.”
Munger knew that when an acquirer buys your business, they write two checks: The first is to you, and the second is to your company to fund its working capital — the cash your business needs to meet its immediate obligations.
When Berkshire bought a business that needed less working capital, they could afford to pay a little more to the owner (over at The Value Builder System™, we refer to this as the Valuation Teeter Totter because as your working capital needs go down, your valuation goes up).
For example, Berkshire acquired See’s Candies in 1972 for $25 million. In See’s, they had spotted a company that accumulated cash as it grew. See’s controlled production and sold through its own retailers, enabling extremely high margins. Plus, customers paid in cash at the time of delivery. And those customers stayed loyal even as See’s raised its price per pound by approximately 10% per year for the first twelve years. The result? Profit rose 19% per year between 1972 and 1984.
In fact, See’s generated so much cash that today, nearly fifty years later, Berkshire has only put $32 million in additional capital into the company — yet See’s Candies has generated pre-tax earnings of over $1.35 billion since Berkshire’s acquisition.
Growing All the Way to Bankruptcy Court
Now let’s consider what happens to the value of your business if it’s a cash suck. For example, when Tyler Jefcoat cofounded Care to Continue, a home health care business, his initial goal was to better serve senior citizens. His “aha!” moment came when he realized home health care workers were rarely treated well by their employees. Just over two years later, Care to Continue had over 100 employees, scores of satisfied clients…and a serious cash flow problem.
While the company paid its employees on time, it had to wait weeks to get paid by its customers. The more the company grew, the worse the negative cash flow cycle became — until one day, Jefcoat found himself with $150,000 in accounts receivable and no money to pay his contractors.
The company had little value to an acquirer and was on the brink of bankruptcy. “We were toast. We almost went kaput,” Jefcoat admitted on Built to Sell Radio.
The cash flow situation needed to change. Fast. So Jefcoat went to every Care to Continue customer and said, “We won’t increase your rate if you switch to paying by credit card or wire transfer.”
He was naturally worried about losing some customers, forecasting at least a 5 to 10% dip in revenue. Instead, Care to Continue didn’t lose a single customer. Because Jefcoat had explained the situation, they understood. Plus, they valued the care their loved ones and clients received.
And since his customers’ payments were received before paychecks needed to be cut, Jefcoat’s business immediately shifted from a negative to a positive cash flow cycle. Another positive result? Jefcoat’s business went from worthless and teetering on the brink of bankruptcy to an offer from a private equity group for five times EBITDA. (Jefcoat’s partner wasn’t ready to sell, so Jefcoat sold his shares in the business back to him.)
How to Tip the Valuation Teeter Totter Your Way
To accumulate cash as your business grows, ask yourself a few questions:
- Instead of invoicing, can you transition your customers to an automated, at time of product or service delivered billing cycle? The quicker you get paid, the better your cash flow.
- Can you transition some of your customer base to a subscription model? You will improve the flow and predictability of your revenue stream, and in the process could build longer-term customer relationships as well.
- Can you start negotiating different payment terms from customers? Ask for a larger deposit or more frequent progress payments. When cash is tight, offering a discount for more favorable terms could make perfect sense.
When it comes to growing your business, you may want to imagine your ideal acquirer is Warren Buffett. The less cash he has to inject after acquiring your business, the greater the value he will place on your business.