Buying a Business: Part 2 of Our Owning a Business Series
In my last article, I provided an introduction as well as an explanation of Phase I of the process of owning a business. I highly recommend reviewing that content before learning more about buying a business.
Part 2 will focus on Phase II and III of the 5 Step Acquisition Process; finding a business, initiation of the Purchase Agreement, Due Diligence, LOI/Purchase Agreement and the execution of the Loan Proposal. This is vital information you need to know about the process of buying a business.
Phase II— Finding a Business/Negotiation of a Purchase Price/Signed Letter of Intent (‘LOI”)
Equipped with a guideline of what you can afford; how do you find businesses that are for sale? A banker that is experienced in this space can help you pull up local broker websites and show you some of the businesses that are on the market. Additionally, they can help you assess these businesses in a manner that allows you to highlight good opportunities and discard poor choices quickly. Once comfortable with the concepts of this exercise, you will then go through the rest of the listings to see what interests you. Additionally, a banker that is experienced in this space will recommend a broker(s) that is focused in a specific industry as they may be aware of listings that aren’t yet on the market but are in the process of moving to ”Listed” status.
After going through the above process, a business that fits your desires should present itself to you. This may be immediate, or sometimes, it may take a year or more. At this point, the conversations with your banker should be about the reasonableness of price and possible purchase structure before making the offer. After having this conversation, you approach the broker that holds the listing and make an offer that you think is reasonable. A Letter of Intent (“LOI”) is initiated, upon acceptance of an offer.
Phase III: Due Diligence/Conversion of LOI to Purchase Agreement/Loan Proposal Letter Execution
Assuming the LOI is accepted as presented, you then move to the due diligence phase of the process. Your specialized banker should be able to assist you with a list of items for this. A good general list to start with for this size of a deal would be as follows:
- Three years of Corporate Tax Returns
- Year to Date Income Statement and Balance Sheet (QuickBooks or similar) with comparable for the same period of the prior year
- Breakdown of Sales by customer for the last two years: This is often more important than what the sales figure is as it helps you determine sales concentrations. Sales Concentrations have increased risk of cash flow volatility.
- Breakdown of Sales by month for the last two years: Helps to understand cash flow cycle and shows the Working Capital need equation (if applicable)
- Equipment List (if applicable—this should also be on the Tax Return)
- Inventory List
- Accounts Receivables list: this will depend on whether you will be acquiring these with the purchase
- Accounts Payables List: this will depend on the structure of the purchase
- List of Employees and Employee Compensation: if applicable
- UCC-1 Search for the Company to ensure any debt that they have is being paid off with the transfer of ownership. This data is discoverable by the Bank and is not provided by the Seller
- Lease of the Facility (if applicable)
- Discussions with the Owners regarding the Sales/Marketing, Finance, and Operational aspects of the business.
In line with the client submitting this list, I always tell the prospective buyer to state to both the broker and the owner that this is Round One of Due Diligence. Round two of Due Diligence will be far less extensive, but there may be four or five items or areas that could not be foreseen up front. As information is received, and analyzed, additional questions tend to arise. It is best in these processes to be clear about your next moves and timeframes—this sets specific expectations for all parties involved and usually leads to better results.
Upon initiation of the Round One Due Diligence package, it is the business purchaser’s responsibility to review this information in detail for obvious reasons. However, a banker that is experienced in this area will also want this information to consider regarding for final loan approval purposes and to offer any insights they may have. Additionally, it is essential to have your Advisory Team in place at this point (which is discussed in Phase 1)—you will want them to review this information as well.
As both the business owner and the banker work through the due diligence items, a critical discussion that I always have with my business purchasers relates to their strengths in business and where those strengths best align in the three main areas of any business—Sales; Operations; Finance. It is rare that an entrepreneur has all three talents; thus, we discuss who (pre-purchase) would fulfill the role for the Company of the areas where the buyer is less apt to excel. In some instances, the person who performs the function is already at the Company—in these instances, we ensure that we have appropriate agreements in place to provide a successful business transition. Also, part of this discussion should decide whether or not the existing business owner stays on for a period and whether a Non-Competition Agreement should be executed as there are specific structures that need to be used to be SBA eligible.
After you have an excellent handle on the due diligence items, I recommend that the Purchaser prepare what we at 21st Century Bank refer to as a “Business Transition and Future Operating Plan.” Although not as in-depth as your original business plan, it is essential for purchases that occur at this dollar amount and are motivated by the buyer wanting a cash flow stream and a working operating system to get started. This includes a strategy to create something with higher cash flow than what they are purchasing through increasing sales, adding complementary product lines, expense reduction (greater efficiency), etc.
The contents of this plan should include the following:
1) 3-year Projection of the Company Financial Performance: this should align with all of the sections discussed below. As an example, if there are employees are being added to the information below, then the Employee Expense on the projection should align with that.
2) Listing of the Advisory Team that is discussed in Phase I
3) Market Analysis of the Company you are buying
4) Your Analysis of where the company that you are buying fits within the market and your vision of other areas that you will be able to service. Additionally, answers such as how you will accomplish the increase; how long it will take; and how much it will cost should be expanded upon.
5) Analysis of Competition presently and in your expansion into other areas—it is essential to discuss your differentiation as you see it currently and with future business lines
6) Sales Plan: Who is in charge of Sales? What is the Plan to ensure existing relationships that produce sales transition well? What is the plan to accomplish the forecasted sales growth—this should dovetail with #3 above? What role does marketing play in existing sales/what part will it have in the future?
7) Operations Plan: Who is in charge of Operations? What is the Sales Execution process presently? How will this be changed Year 1—potentially Year 2 or 3? How many people are involved today—what part of the process are they engaged in? How will this set-up change?
8) Finance Plan: Who is in charge of Finance? What accounting system will they be using? What are their credentials/understanding of the system? What cash is needed in the opening checkbook to fulfill the need of Years 1 – 3? What is this based on? Is it in the present loan request? Are there complexities like Accounts Receivable days, Account Payable days, etc. that need to be explained to help understand the working capital need better?
How many pages should it be? As many as would be needed to ensure that the Business Owner is prepared to Execute Day One that they own the business, as opposed to planning. Planning takes time away from execution—this is why it is done during the Due Diligence Phase and not Day One after they complete their business purchase.
The Banker and the prospective business Purchaser should then have a meeting to discuss the Business Transition and Future Operating Plan, as well as both of their takeaway items from the due diligence and how it would affect the business purchase structure. Again, having the banker involved throughout this process should lead to faster loan approvals and fewer surprises. Keep in mind that Loan Approval has not happened yet, but the Banker has provided much input into this process. An additional side concept to note, if a Business Purchaser does not take the Plan nor Due Diligence seriously, this can very much decrease their possibilities of getting their loan approved. This part of the process provides the Lender with its final assessment of Business Acumen of the Prospective Business Owner that is discussed above.
The Business Purchaser then converts the LOI into a Purchase Agreement for submission to the Seller’s Business Broker. Depending on the level of depth of information you receive before submitting your LOI, there will be either many changes to the Purchase Agreement or few. From my experience, most Sellers are reluctant to give Prospective Buyers much more than the Operational Result Summaries and some amount of written history on the business. It only then makes sense that after receiving all of the other items, the deal may have some changes to it or introduction of new concepts.
If the Purchase Agreement is negotiated and executed, the final loan approval starts. The best part of this 5 Phased Process is that the bank has been a part of the process every step of the way. They would be hard pressed at this point to enter new concepts into the loan deal or to turn down the loan. The loan prior to getting approved will be final structured at this time—a typical structure for an SBA 7a loan for this size of purchase would be as follows (please note that this is simply meant as an example—our Bank is well aware that Seller Financing can be involved; more down payment can be present, etc.):
Uses of Funds (*):
–Business Purchase: $500,000
–Working Capital: $20,000***
–Closing Costs (est): $15,000 ****
Sources of Funds (**):
–Cash Down payment: $53,500 (10 %)
–SBA 7a loan amt: $481,500
Loan Term: Up to a 10-year amortization
- Interest Rate: Variable quarterly with Wall Street Journal Prime (the Spread over Wall Street Journal Prime is dependent on the strength of the loan transaction)
- Collateral: UCC-1 on All Business Assets
- Personal Guarantees of the Business Owners
- Personal Collateral (2nd REMs on houses if a business collateral shortfall exists)
- Life Insurance if there is only One Qualified Owner to run the business
- *: This is another way to say, “What do we need to pay for?” Moreover, this is where I start when structuring a transaction.
- **: This is another way to say, “How do we fund, what we need to pay for?” And this is Step 2, as we know that there is a specific percentage down payment that we need per the SBA’s Standard Operating Procedures (SBA SOP). The difference then between the Total Uses and the Cash Down payment is our SBA 7a Loan Amount.
- ***: This can differ depending on the type of business and the structure of the purchase (the involvement of Company Cash, Accounts Receivables, and Accounts Payables). This is another significant benefit of the SBA 7a program and a part of the loan structuring that is often forgotten by non-Business Acquisition Specialists.
- ****: This will differ by loan. In this example, primarily this is the Fee that is paid to the SBA for the guarantee of the loan (SBA Guarantee fee). Keep in mind that the debt being issued is very reasonably priced Debt that is likely more closely aligned to Unsecured Debt than well-secured Debt. Also, there are often risks present such as transition risk and the collateral shortfall that is being mitigated by the Guarantee of the government. Additionally, when the fee is spread over the 10-year term of the loan, the fee is very reasonable.
Let’s look at the benefits of the SBA 7a structure above:
1) 10 % Cash Down Payment vs. Conventional loan down payment of at least 20 % or more likely far higher (this is again due to the lack of collateral, and conventional loans lack the SBA Guarantee)
2) Reasonable Working Capital included an Acceptable Use of Funds
3) 10-year Amortization vs. Conventional loans of 5 years for this type of product
In sum, not only does it expand the potential pool of business owners through its decrease of the Risk of Loss Component of lending, but it also decreases cash down payments, allows working capital inclusion, and gives 10-year amortizations. These three factors individually will increase flexibility for business owners as they transition a business they are purchasing but coupled together, they can exponentially increase your cash in the business when you need it most—your first few years during a business transition.
Once the Bank and the Prospective Purchaser execute the Loan Proposal Letter, the Loan enters Phases IV and V. The process should be downhill at this point if the first three Phases are followed in the manner discussed above.
Article Contributor: Jonathan Dolphin, President, 21st Century Bank