Are you interested in owning a business, but don’t know where to start? Part 1
An Advisor’s Approach to Business Acquisition SBA 7a Lending
Far too often that First Time Purchasers, looking at owning a business walk into a large bank with no referral, and they end up getting less than the proper guidance for this transaction, or they go to a community bank that originates “C & I loans,” but doesn’t specialize in this type of lending. This is not C & I lending in its traditional sense—this is commonly Cash Flow Lending that has minimal collateral to secure the loan, thus a higher degree of collateral risk (risk of loss to the bank) being mitigated by the Guarantee from the United States Small Business Administration (“SBA”). A large percentage of banks are not comfortable with this type of lending, so my suggestion is to find one that is certified as an SBA PLP Lender.
Also, this is not a standard banking product; it is Specialized Lending. By not going to the right people, it leads Business Acquirers to either get the wrong product at the wrong time (business transition), or it leads them to become so disenchanted that they give up their dream altogether.
5 Phased Acquisition Process
Phase I: Pre-Qualification/Preparation
Phase II: Finding a Business/Negotiation of a Purchase Price/Signed Letter of Intent (‘LOI”)
Phase III: Due Diligence/Conversion of LOI to Purchase Agreement/Loan Proposal Letter Execution
Phase IV: SBA Packaging
Phase V: Loan Closing Documentation Preparation/Closing Occurrence
This is Part I of a two part series.
Part I, will focus on Phase I and Part II will provide you with insights on Phases II and III will which will be posted by mid-next week. Phase IV and V will not be addressed specifically—this isn’t because they aren’t specialized or detailed. It is because if we’ve completed the steps in Phases I – III and set expectations appropriately, Phase IV and V are a downhill motion.
Who should read this?
· First Time Business purchaser (Primary)
· An Individual that has purchased businesses multiple times may pick up a more streamlined strategy from reading this
· Any advisor to a Small Business or Prospective Small Business owner
· Business Brokers
What specific purchase characteristics are we reviewing?
· Business Acquisition
· First Time Purchaser
· SBA 7a product
· Purchase Price (and working capital need) under $500,000—this is being focused on as this is the largest percentage that I see for first-time business buyers. Our bank has done loans on
first-time purchases up to the high end of the SBA product amount; however, the expectations for approval on the financial strength of the guarantor and business acumen/experience are different from the contents of this article.
· Located in the seven-county Metro Area of Minnesota, and additionally Wright and Sherburne Counties
Just a reminder, this is not an article for Business Start-up. This will be addressed in a future article.
Why Write About This?
Goal 1: If you are a first-time purchaser of a business, this article will give you concepts that you can work through to plan out your future move from a W-2 Employee working for a Company to a Business Owner, before meeting with a Banker.
Additionally, you will become familiar with the steps that occur in closing this type of purchase. The quickest movement from start to finish (Phase I to Phase V), I have had is 90 days. The longest is a lack of occurrence (as the Buyer worked through the process and couldn’t find a business that made them feel comfortable). Keep in mind that the 90 days to no occurrence range isn’t discussing closing a loan product, it is the whole process, as I don’t view this process for a first-time buyer as a product, but rather a relationship transaction where the banker is involved in all five steps that are detailed above.
Goal 2: Often, when this type of transaction occurs the steps occur out of order, which I have found creates a considerable amount of inefficiency. The 5 Phases are a Game Plan—if executed correctly and with commitment and sophistication, the loan process can work quite well. However, too often Prospective Purchasers start with Phase I not occurring first and instead beginning at Phase II with the Prospective Owner working with a Broker and without a banker. This is a disservice to the Prospective Business owner, the Seller, and the Broker, as no one knows whether the Buyer is qualified; whether the Prospective Owner knows a bank that specializes in this transaction; whether he or she knows what the steps entail so they can work backward to reach a closing timeframe.
A banker is too often brought in to the game at the end of Phase III—when there is an expectation of Loan Proposal and that it be completed in short order. However, commonly, previous steps were skipped, textbook due diligence was missed, etc. At this point, the bank is behind because we are starting at Phase I, while everybody else believes they are genuinely at Phase III.
What does it cost you for a banker’s services—outside of Interest, given that these services are more extensive than what banking would typically do?
The only costs to a business owner that are paid directly to a bank are a market rate SBA 7a loan packaging fee and market rate interest. Believe it or not, this process may seem like a lot of work for a banker, but I find it to be more efficient because we stay involved and are on the same page with the client.
Is owning a business for everyone?
No, it indeed isn’t. You have to be willing to put in whatever time it takes you to get the job done. Work/Life balance should occur at most times, but there will be times where a horn doesn’t go off signifying the end of your day; you can’t punch out your “stone” time card at 5 pm; you are unable to slide down the dinosaur and get in your car to go home and be with your family (reference, Flintstones). There is certainly sacrifice and additional commitment involved, but I see a lot of reward and pride from the business owners that I work with up front and those that had decided to work with me when they were already seasoned in business.
To conclude this question, I would state that with the right information and guidance, owning a business can be for more people than it presently is.
This Phase begins typically with a person who is interested in owning their own business, but doesn’t know what is required; the steps involved in the process; or is slightly uncertain of which direction they are going to go regarding keeping their W-2 job or moving forward with a business acquisition. To elaborate on the uncertainty of direction: a common fear is they confuse business acquisition with business start-up in their minds. Business acquisition (if done correctly) should start you out with a cash flow stream that is solid relative to the debt and what a business owner needs to take home to manage their budget. I see the fear of the start-up as you are starting with a requirement to create all the processes and systems, as well as produce a significant amount of sales day one. This isn’t saying that there aren’t times where start-ups make sense, this is meant merely to show that the fear can sometimes be misplaced.
Assuming you are at the right bank (see opening Questions above on what isn’t the right bank) and after careful thought, you would like to pursue a business purchase, the next step is to present the bank with the following information:
· Personal Financial Statement that is filled out correctly: This is a document that will present your Assets and Liabilities personally (Home Value, Home Mortgage, Cash, Retirement, etc.) and also will discuss your monthly personal budget (Income v. Expenses). Have your Financial Planner assist you with filling out this form or at least bring the backup information to the banker can help you fill it out.
· Personal Resume that is up to date
· Free Credit Report—the bank will eventually pull their own down the road, but this way if the process is long, your credit score doesn’t get lowered due to the number of inquiries.
· Three years of Personal Tax Returns
The goal of these items is so that a bank will be able to answer four (4) questions related to your statement:
1) How big of a business can they buy? This is based on how much cash you have on your Personal Financial Statement. For example, if you have $70,000 in cash saved up, then most would not want to invest more than $50,000 (leave a cushion personally). $50,000 is 10 % of $500,000. Thus, we know that from cash down payment standpoint, we can buy a business that costs on the high end, $500,000
2) Typically lenders use a credit score more than 700 with no derogatory events as a benchmark for good or acceptable credit. There is some amount of room for this requirement; however, the lower it is from this, the less probability of approval.
3) Does your resume and Personal Tax Return history (rising wages/good decisions) show Business Acumen relative to the size of the business and Industry Experience? This along with your organization, clarity about your personal situation, an explanation of why you want to buy a business contribute to a banker’s assessment of you in this area.
4) Does your Personal Income requirement make sense relative to the size of the business that you can buy and also other household income? The answer of “I will grow the business to the level I need to make” isn’t usually a good answer, as this takes time. A business transition has time and risk involved—if you add to it an immediate need to triple sales to support personal income need, the hypothetical owner will be financing mortgage payments through credit cards. This is not the goal, nor sustainable.
In sum, if you are going to need a paycheck from the Company that you are purchasing, we will need to ensure that it fits within the cash flow availability of the business after debt service.
The bank then should be able to give you a dollar value range that you can purchase, but it will be subject to review of the following items when you find a business that you would like to purchase:
1) Business being purchased is at a reasonable multiple of cash flow for the Industry. All Assumptions utilized to determine free cash flow (EBITDA—Earnings before Interest, Tax, Depreciation, and Amortization) are reasonable. Reasonable Multiple of EBITDA is being paid for the business when factoring in the industry. The simplest way I can explain a multiple is that it is a representation of the predictability of the future cash flow, which can have a lot to do with the volatility of the Industry.
2) Sales aren’t concentrated on one (1) or a few sources—this leads to extra volatility and risk. This can lead to adjustment of the free cash flow or the multiple that the business is worth, depending on the situation.
3) How the four answers from the Personal side above interrelate with the answers to the two questions in this section.
Finally, they are going to ask you whether you have your advisory team put together:
· Wealth Manager
· Insurance Agent
You don’t need to have all of these in place at the time of the meeting, but you should have some due diligence in your possession. Your banker should also be able to recommend professionals in these fields that specialize in small business and that reflect similar ideas to them.
On the flip side if you went through Phase I and it was deemed that you weren’t qualified for one reason or another, I would lay a plan out for you as to what you would need in order to buy a business in the future or I would offer that you could look for companies that offered Seller Financing. Obviously, if lack of down payment is the hurdle, then Seller Financing probably isn’t even an option as most of these require some amount of down payment.
Part II of this article will be posted mid next week on defining out Phase II and III.
Article Contributor: Jonathan Dolphin, President, 21st Century Bank