Capital expenditures (“capex”) are investments made in your business that increase your asset base over the long term. Common capex items include new machinery, tooling, vehicles, land, IT systems, office equipment, leasehold improvements, etc. These items are capitalized and show up as assets on your balance sheet as opposed to expenses which flow through your income statement. Capex is required to maintain and/or grow your business, and there is a difference between “growth” capex and “maintenance” capex that business owners should be able to differentiate.
Growth capex is exactly what it sounds like: investments made to grow your existing base of business. For example, let’s say a local craft brewery is limited by its bottling line. The Company is planning to add a second bottling line at the cost of $120k, hence doubling capacity. The investment in a second bottling line used to increase current capacity is an example of growth capex.
Using the same hypothetical scenario, a brewery that has to make an investment to replace or repair its current bottling line due to wear and tear will need to invest maintenance capex to maintain the current level of production. Maintenance capex is the normal investment required to keep a company operating at status quo and is a real cost of doing business.
When selling your business, buyers often consider how your company’s capex requirements (both maintenance and growth capex) impact free cash flow. Heavy manufacturing companies or logistics companies with large rolling stock fleets need to reinvest cash flow into their business to fund regular operations, limiting the availability of cash to support debt service. In fact, businesses with high capex requirements may be valued on EBIT (Earnings Before Interest and Taxes) as opposed to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to include depreciation and amortization and better reflect the earnings potential of the business.
Not all capex is created equally. When growth capex is invested prior to a sale, both buyer and seller should consider future cash flow to determine appropriate valuation and deal structure. A seller should not be dinged for an investment they made today that a buyer will benefit from tomorrow unless the investment is made to replace an existing asset. To learn more about other variables that affect the valuation of your business, read our blog posts on value drivers and value “dingers”.