By: Jay Whitney
A childcare center business valuation needs a reasonability test. One critique is a purchase price justification test, which confirms whether a lending institution could finance the childcare business at its estimated value to a qualified buyer with a reasonable equity stake. This test confirms whether a business’s cash flow can finance the acquisition debt, provide a return to the investor, and compensate the new owner operator for the time and effort that the new owner puts into the business.
Potential business buyers value a childcare business using the debt-paying ability of the business. Most business buyers are required by lenders to provide a 10% to 20% down payment of the Total Acquisition Price of a childcare center, therefore, a typical childcare business buyer finances 80% to 90% of the Total Acquisition Price. The Seller’s Discretionary Earnings (SDE or “cash flow”) of the business should support the debt service, return on equity invested, and compensation for the new owner. A simple example:
In this example, a Total Acquisition Cost of $800,000 supports the debt service, return on equity invested, and owner’s compensation as long as the SDE/cash flow is at least $227,000. If the cash flow was exactly $227,000, a higher acquisition cost would not support the debt service, unless the business buyer was able to get better terms on the debt, or would require less than $100,000 compensation or less than a 25% return on the money invested. This confirms to the buyer that a multiple of 3 times the SDE is acceptable.
In this example, the total yearly cash flow available to the new owner is $130,000. Note that this example simplifies many factors, including the deal structure and the resulting effect on taxes which in turn affects the cash flow, and therefore the price.