“We make a lot of money, but we also spend a lot of money.” Josh (not his real name) was facing an existential crisis in his business. Though his company generated annual revenue of about $8 million, Josh could never turn the corner of making much money.
I told Josh I’d study his financials to see if I could help him figure out his problem. He was hoping to sell the business within the next two years. But, if we couldn’t unlock the secret to why he wasn’t generating much cash flow, we wouldn’t find a buyer willing to pay much for the business.
Josh’s business was fairly stable. His cost of goods sold was about 31% of revenue, and operating expenses seemed to hover around 60% of revenue. So, the business was making about 9% profit margin per year, about $700,000 per year. But by the time he paid taxes, payments to the bank for the loan on his plant expansion in 2013, and the normal capital expenses required to keep his equipment current, there wasn’t much cash to go around.
Josh explained his predicament. “My dad sold me 70% of the business, but he expects a healthy and regular dividend on his 30% share. You see, that dividend is his retirement and he has a rather expensive lifestyle at a golf community in Florida. After I pay his dividend, there’s usually little left for me.” Josh went on to say, “I’m working so hard, this doesn’t seem fair, but I don’t know how to resolve it. That’s why I just want to sell the company. My wife is an ER doctor, we can live on her salary. She wants me to do that because she says the stress is killing me.”
My study of Josh’s financials led me to a startling conclusion. He was using a line of credit from his bank to pay the dividend to his father. Most years, Josh has a profit “on paper,” hence his dad is theoretically owed the dividend. But, the paper profit does not reflect the reality of his cash flow. After loan payments and necessary capital expenditures, there usually isn’t enough cash to pay the dividend. That’s why Josh has to rely on the line of credit to pay the dividend to fund his father’s “large lifestyle” (Josh’s words, not mine).
I later met with Josh to review my findings. Since businesses are valued on the free cash flow they generate, the valuation expectation I gave Josh wasn’t very exciting. By the time he paid off his debt, he wouldn’t have much to distribute, and certainly not enough to support his dad’s lifestyle.
Josh is stuck between a sharp rock and a very hard place. If he wants to help his father, he can’t sell and will have to continue to live off the line of credit to fund his father’s retirement. But, if Josh takes his wife’s advice and sells the company, he’s likely to live longer. I’m not King Solomon, so when a client faces a Hobson’s choice like this, all I can do is define options. A hard decision lies ahead. But one common theme emerges from this story. A line of credit can become an addictive drug for the business owner. There are certain times a line of credit is important, indeed necessary. But there are many times when a line of credit is a Band-Aid over a problem that will only get worse if not addressed.
JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. http://www.amazon.com/Home-Pros-Guide-Selling-Business/dp/1599329239 . He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The story above is true, but the names and fact patterns above have been changed to preserve the parties’ identities.