Published on Friday, May 9, 2014

How to Successfully Buy a Profitable Business

A Step-By-Step Guide To Getting Your Piece Of The American Dream - Final

5.  How much is it worth?

When it comes to pricing the business, you have to keep in mind that there are usually two values to consider.  First, there is the Seller’s asking price which is almost always overly optimistic. In fact, most business sellers cannot identify a single widely acceptable valuation method.  They will generally say things like, “well that’s the price that I need to get out of the business.”  Or, they will want to base the price on the value of equipment tied up in the business as if the equipment was brand new.

The second value is based on the company’s cash flow, because that’s what you or any other buyer would be actually purchasing.  If the difference between these two values is relatively small, then you have a reasonable chance of striking a deal.  If, on the other hand, if these two prices are off by say a factor of  2- that is one is double the other - then you would probably be better off pursuing another deal.

According to the ”market” data of  “real” sales, most small businesses actually sell for approximately  2 to 4 times Adjusted Net or Seller's Discretionary Earnings (SDE). With few exceptions this is almost always the case. Please note, this information applies to small, privately held firms with annual revenue of $2 million or less. These are not to be confused with large publicly traded firms who trade at 10 to 20 times earnings or more.  For certain industries or business types the factor might be a little lower like 1.8 times SDE; still others might command a slightly higher multiple of 3.5  to 5.0.  But if you look at a cross-section of  small businesses, you will see that the multiple is right around 2 to 4.  The exceptions are high demand businesses,such as gas stations and popular fast food establishments that will sell for 4 or 5 times SDE.

One thing to remember is that the higher the SDE multiple -- the lower the rate of  return on your investment dollar.  For example, 2 times SDE means the business pays for itself in 2 years or 50% per year. Similarly, a multiple of 3 results in a 3 year pay back or 33% per year.  A 4 times SDE is really a 25%rate of return.

It all makes sense when you think about it for second.  If  you find a business making a SDE of $200,000per year and you pay $800,000 for it, then your multiple is 4, and your rate of return is 25%.  Or, to look at the same deal another way, if you had $800,000 in the bank or in a mutual fund and you were able to get 25% rate of return on your investment - then your investment would be generating $200,000 a year in earnings.

So, if you can keep your SDE multiple at 3 or less, you make sure that your rate of return stays up around 33%. It’s just that simple.  And when you add leverage to the equation, the rates of return - even after you make your loan payments - your “cash-on-cash” rate of return can be higher than 100%!  Here’s how leverage [or borrowing] helps you to get a Rate Of  return on Investment(ROI) of better than 100%:

Note:  The example below is for illustration purposes only.  Your actual results may vary.

·        SDE of $150,000; and Purchase Price of  $300,000 (2 x SDE)

·        Cash Down Payment of  10% or $30,000

·        Net SDE after loan payments  (Prime + 2% for 10 years)  -- $106,000 per year

·        Cash-On-Cash ROI = 353%!  ($106,000 divided by  $30,000)

6.  Making written offers.

Once you have determined the price that you want to offer, the best thing is to get it in writing and present it to the Seller yourself or through your broker / intermediary.  As simple as it sounds, it is very important that your offer be in writing.  Many times a potential buyer may be talking to the owner and ask a question like,“well, how do you feel about a price that’s substantially lower than the one you wanted?”  The buyer is then dumbfounded when the owner rejects this verbal offer out of hand -  with no hesitation whatsoever.

It’s not that a lower offer is such a bad deal, and gets rejected just because it’s so low. Many times the reason many “trial” offers aren’t taken seriously is that they are verbal.  You see, something  rather mysterious happens when an offer is reduced to writing.  All of a sudden,something that seemed a little ridiculous before is now given some real consideration.  The bottom line is this:Most businesses on the market may not be worth the asking price, but they are worth something.  The trouble is that most potential buyers would rather walk away from a deal, rather than put down an offer that results in an excellent ROI..

What usually happens is this:  A potential buyer finds a business that’s for sale at an asking price of $500,000.  The owner claims that the SDE is about $175,000 per year. After checking the books and records, our buyer prospect finds out that the business is really  producing about $90,000 in solid cash flow.  Now, this is where things get interesting.  What does  the buyer usually do? He or she will just walk away and say that the “business isn’t showing enough income.”Or, they will ask the owner or broker, “do you think a $180,000 price would be acceptable?”

The better way to handle that same situation might be to write up an offer of less than 2 times SDE, say $170,000, and then wait for the seller / owner response.  Establish a top price of  around $180,000.  So, if this deal is accepted, then the ROI is at the 50% level.  The approach  is that the business - from the buyers standpoint - may not be worth $250,000 or even $200,000 - but it can be purchased for $180,000 or less and be an excellent investment ... especially, if it has semi-absentee ownership potential. But you have to make a written offer every time if you want to have your deal considered.  Sometimes the owner will become quite angry over receiving a low bid, and in other cases, the offer will be just enough to make her / him lose a little sleep. Note: this is a good reason to use and intermediary as a buffer between buyer and owner.

7.Structuring the purchase.

Flexibility is the key to structuring the right deal.  I know we talked about 4 times SDE as being the upper limit on pricing decisions.  But that formula assumes that the purchase will be paid for in cash or near cash. Many times businesses are financed in large part by the owners themselves.  Typical terms might be 1/3to 1/2 of the purchase price as a cash down payment, then the balance would be carried by the seller.  Proceeds from the business (SDE) would be used to repay the outstanding loan.

The thing to remember is that the price you pay becomes less important when you are able to get excellent terms -particularly from the seller.  You may be willing to pay a slightly higher price than even 4 x SDE if the owner is willing to loan you a substantial portion of the purchase amount.

Seller financing has played a major role in how many business sales transactions have been financed.  More recently Congress and the SBA have loosened the reins and streamlined the loan approval process. Business acquisition loans can be processed and approved through what are known as Preferred Lenders.  It is through this Preferred Lender Program  (PLP) that you can be “pre-approved” in a few days as opposed to months.  The other real positive thing about PLPs is that they are business people and the strength of your proposal lies in the strength of the business you would be buying. The stronger the business, the less reliance on your personal resources in making the loan decision.

You will need demonstrate the availability of personal resources, but the actual requirements are probably a lot less than you think.  In order to be considered an excellent candidate - depending on the structure of the deal - be prepared to show following:

·        At least ten percent (10%) of the total purchase price in cash. This assumes that the real estate would be purchased as part of the business acquisition. If purchasing just the business assets, be prepared to show twenty-five percent (25%) of the acquisition price in cash.

·        A solid credit history.  This doesn’t necessarily have to be A+, but it should be good.

8.  Making sure it’s all there.

So now you are feeling real good about the deal you just made.  The price is right,your financing shouldn’t be a problem, and it looks like it’s going to be smooth sailing straight on through to the closing.  It’s a nice picture, but the reality is that at the point that both potential buyer and seller agree on the basic deal is when some of the real work begins.

You now have to begin the process of double-checking and verifying all the information you have been given up to the point of  offer and acceptance.  The more formal term for this process is “due diligence.”  That’s the process of going through and making sure that everything is as represented to you by the owner or  the owner’s agent or advisor.

According to Business Brokerage Press, the three top reasons that deals don’t close after the offer has been signed and accepted is usually because of one of the following:

·        During the buyer’s investigation of the books and records, she or he discovers undisclosed problems, less than expected income, or other financial deficiencies.

·        The seller’s inability or failure to provide necessary documentation or other information. This also includes the seller’s deliberate refusal to cooperate.

·        Unknown or undisclosed external issues with federal, state, or local governmental agencies.

Many of these challenges can be overcome or minimized when you get outside or institutional financing.  That’s because the lender will do most of the due diligence for you.  Well they don’t actually do it for you - they do it for themselves.  It’s real simple.  The lending institution is going to do everything in its power to make sure that the business you want them to finance, makes enough money to give you a decent living and still be able to pay back the money you owe.  This is a great benefit for you.  Financial analysts and underwriters working for the lender will check the financial statements and tax returns very carefully.  They even make sure that the returns are authentic by requiring the business to file a "transcript request" form with the IRS.

Of course, you will nevertheless want to do your own assessment of the business regardless of the amount o lender involvement.  Most importantly,you want to know as much as you can about how cash flows into and out of the company.  This is done in much the same manner as the SBA or institutional lender does it.  Obtain at least  3 years financial statements and tax returns.  Look for trends and wide swings.  Often times, especially in the case of  retail businesses, or any business that handles large sums of currency, you will need to look at sales receipts and bank deposit statements.

In certain circumstances, it may be necessary to actually go to the business and physically observe the operation.The reason for this is that owner will whisper in your ear that the business generates more cash than the owner is reporting.

Naturally, the owner believes that he or she should be compensated based on an inflated earnings base.  Therefore, (in the seller’s mind) the price you pay should take into account the cash that the owner is taking out of the business but not reporting.  Well, you can look at this in a couple of ways. One way is to say to the seller, “Mr. / Ms. Seller you have already been paid once because you were able to enjoy money that should have gone to pay the IRS.  So, you don’t expect me to pay you again ... do you ?”

Another, more serious challenge,comes up when you want to get an SBA acquisition loan and there is unaccounted cash flowing out of  the business.  The lender will only loan money based on what can be proven and verified.  If this is the case you may end up walking away from an otherwise good deal.  On the positive side, you uncover problems before you invest more time and money into a losing proposition.

Many of the potential problems or stumbling blocks in the due diligence process can be handled by your team of  professionals.  When it reaches the latter stages of a transaction you would be well advised to have at a minimum - a competent intermediary and an accountant experienced in business sales transactions.  This is definitely no time to  “scrimp”.  Any money you invest in the professionals will be well worth the potential headaches and difficulties you avoid down the road.

9.  Before you take over.

Around the same time you are completing the due diligence process, and lining up the financing (either third-party or seller), one other critical task must be completed. Unless you are purchasing the building as part of the business, you will need to have a signed lease agreement with the building landlord .  In that case, you must secure either an approved  lease assignment / assumption or obtain a new lease.

The other very critical task to be completed, is the Bulk Sale Transfer.  A bulk sale is defined in the Uniform Commercial Code as a “sale not in the ordinary course of the seller’s business of more than half of the seller’s inventory and equipment, as measured by the value on the date of the bulk sale agreement.”  This means that when a business owner sells her or his business there are certain requirements that must be met.

Depending on the customs and laws governing the state where you reside, this process is done by an escrow agent or an attorney.  The agent or attorney publishes and record a Notice to Creditors of Bulk Sale.  This filing is followed by a period of time in which creditor claims can be filed with the escrow agent.  Valid creditor claims are presented to the seller for approval prior to the close.  The purpose of this is to make sure that the buyer receives clear title to the assets being purchased.

The escrow agent also sends notices to various taxing agencies, such as the county tax collector, and the Internal Revenue Service. These agencies are requested to forward a "Release of Buyer” acknowledgment to the escrow agent on behalf of the buyer. The reason for the release is to protect the buyer from any liability for any unpaid debts the seller may owe to these agencies

Once the major tasks are complete,then all that has to be done is to transfer or set up the necessary accounts,services, licenses, and permits. Examples would include the following:

  • New Bank Account
  • Utilities and Telephone
  • Local Business License / Permit
  • State Operating Permits
  • State Employment Account
  • Federal Employer Identification Number
  • Business Insurance

This is just a partial list, but it should cover most of the requirements for your area.  Again,work with a professional intermediary who can help guide you through this final process.  You will be glad you had this assistance once things really get going.

When all this is complete, then you are ready to take the keys and become the new owner. At that point I only have two suggestions:

1.     Listen very carefully to the “former” owner and take his / her counsel very seriously during the training process.

2.     Don’t make any changes at all for the first six months or so.  Change is difficult for most people: employees, customers, and suppliers.  So wait to implement those improvements. 

Summary

We have just explored a tiny part of the small business world.  There are literally volumes of  information written about the subject. My hope is that this report has given you some valuable insight into the opportunities and the mechanics involved in buying a small business. This is just a sketch.  In order to gain the full benefit from all that ownership has to offer, you will need to put what you have learned into practice.  Be creative ... stay focused ... persevere... and success will be yours.

The only way to get where you want to go, is to take actions that move you in your chosen direction. The key word in the last sentence is action!.  There is just no getting around it.  Although you may still feel somewhat unprepared, remember that there are professionals available to help guide you along the way.  Learn to work with these people for your mutual benefit.  When you seek the counsel of competent advisors, every problem is tempered and you never have to go it alone. Take a look at every great leader in business or politics and you will find that - with very few exceptions - these people share a certain characteristic.  Great leaders surround themselves with the best people.


In closing I would like to wish you prosperity and success beyond your wildest imagination.  Good fortune!

 

Lewis W.Martin, CVA

Business Intermediary / Certified Valuation Analyst

United Business Investments

24301 Southland Drive, Suite 409B

Hayward, CA  94545

lmartin@ufsglobal.com 

www.united-business.net

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Author: Lewis Martin

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24301 Southland Drive Suite 409 Hayward, CA 94545 Direct: (510) 397-1942  eFax: (510) 315-0145 Email: info@united-business.net

Licensed by CA Bureau of Real Estate ID: 01186051