Small business investing: cash flow vs. appreciation

Cash flow and appreciation are two distinct financial concepts often associated with investments, particularly in the context of investing in real estate or small businesses.

Cash flow represents the income or revenue received from the investment after deducting all expenses, including operating costs, maintenance, and financing expenses (e.g., mortgage payments, SBA loan payments, etc.). It is typically calculated annually even though distributions may be made on a more frequent basis (e.g., semi-annually or quarterly).

Appreciation refers to the increase in the value of an asset over time. This increase can be due to various factors, including market demand, economic conditions, growth of the business, improvements made to the asset, or increasing profitability. 

While cash flow plays primarily generate returns through distributing operating profits, appreciation plays primarily generate returns through a future liquidity event.

Liquidity Events in Small Businesses

A liquidity event is a significant financial event that allows stakeholders in a company to convert their ownership stakes into cash or other liquid assets. They are particularly important for appreciation plays, as it doesn’t matter if the value of your ownership goes up if there’s no way to realize it! Some common types of liquidity events include:

1. Sale (Acquisition): A sale is the most common form of a liquidity event. It occurs when a company is acquired by another company, either through a full purchase of its assets or the acquisition of its equity. The sale may be paid for in cash, stock in the new entity, or a combination of the two.

2. Secondary Transactions: Sometimes entrepreneurs negotiate an equity call. This means they have the right to buy out investors at a certain point in time for a certain price. If they choose to execute this right, then investors would see a liquidity event in the form of a share- (C-corp) or unit-buyback (LLC). Alternatively, some investors may negotiate an equity put. This means they can “put” their holdings back to the company and force a buy-out of their ownership.

3. Recapitalization: Recapitalization is a financial restructuring strategy in which a company changes its capital structure to create liquidity. It may involve taking on additional debt, issuing new equity, or altering the company's ownership structure. In some cases, recapitalization can lead to a distribution of cash to existing shareholders.

4. Merger: A merger is a business combination in which two or more companies combine to form a single entity. In a merger, shareholders of the merging companies may receive shares in the newly merged entity, cash, or a combination of both. A merger can result in liquidity for shareholders if they opt for cash or sell their shares in the merged entity.

How Small Business Investments Appreciate

Small businesses can increase their value through two levers:  (1) growing EBITDA, or (2) experiencing multiple expansion from entry to exit. 

Growing EBITDA

Growing the profits is often the easier of the two strategies. It can be achieved through a few means:

1. Revenue Growth: One of the primary drivers of EBITDA growth is increasing revenue, assuming the profit margin does not decline by more than the revenue increase. Revenue growth can come from expanding a small business’s customer base, launching new products or services, adjusting pricing, or entering new markets to boost sales.

2. Cost Management: The other way to boost profits is to reduce expenses. Typically, there are two categories: cost of goods sold (COGs) and operating expenses. Depending on the industry, one may be easier to budge than the other. For instance, perhaps there is a lower-cost supplier (decrease COGs) or there is an opportunity to streamline payroll and remove redundant jobs.

3. Increasing Scalability: Small businesses that have scalable models can grow their EBITDA without a proportional increase in costs. Scalability allows for incremental revenue growth with minimal additional resources.

Multiple Expansion

Multiple expansion refers to an increase in the valuation multiple applied to a company's EBITDA. To calculate an entry multiple, you would take the purchase price for the business and divide it by the earnings at that time. There are a few mechanisms for increasing that multiple:

1. Improved Market Conditions: This often occurs when market conditions are favorable, such as in a strong economy or a hot sector. Investors may be willing to pay a higher multiple for businesses with growth potential. Recently, HVAC and pest control have experienced a boom of interest leading to higher multiples for the same business. On the flip side, increased interest rates hurt the multiples for almost any sector.

2. Focusing on Transferability: Many small businesses are heavily tied to the owner. By investing in making the business more transferable, buyers will often pay higher multiples as there is a bigger universe of people who can credibly buy and own it. This can be done through transitioning from family members to true third-party employees, hiring a GM, promoting internally, and outsourcing.

3. Predictable Financial Performance: Consistent and predictable financial performance can attract investors and buyers, leading to multiple expansion. Businesses that can demonstrate sustainable growth and stability are often valued more highly, as there is more confidence in the numbers continuing into the future

4. Developing a Competitive Advantage: A small business with a unique competitive advantage, such as proprietary technology or a strong brand, may receive a higher valuation multiple due to its perceived strength and growth potential.

Generating Cash Flow in SMBs

Cash flow investors generate returns in small businesses by prioritizing regular and consistent income streams, often through the regular distributions, one-time dividends, and the pass through of losses and depreciation.

1. Quarterly Distributions of Excess Capital: Cash flow investors aim to generate income through regular distributions of excess capital generated by the small business. These distributions may occur on a quarterly, semi-annual, or annual basis, depending on the business's cash flow and distribution policies. 

2. Dividends from Equity Ownership: Apart from investments that have a regular distribution cadence, others may allot to make one-time dividends available to investors. These dividends may come from the sale of certain assets, a spin-off of a business unit, or excess cash that doesn’t have a clear need to be reinvested.

3. Depreciation and Loss Pass Through: For SMB investments into an LLC, the passive investors are able to share in any depreciation or losses recognized by the business. While on the surface, this is a bad thing, it helps reduce the tax burdens of investors. Many actively look for investments where they will be able to access depreciation.

The Importance of Aligning Goals with the Ownership Group

Before pursuing a transaction, investors should assess whether the management's goals and acquisition target align with their investment strategy. Investors should inquire about the management team's aspirations, such as whether they aim to grow the business, maintain its current state, and how they plan to generate returns for investors. Some entrepreneurs may prefer to distribute profits regularly and have a path toward buying out investors, while others may want to reinvest aggressively for growth and sell at a higher multiple to a private equity fund. 

Given that SMB transactions are the start of a sometimes multi-decade journey, it's critical to align on expectations early and often.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.