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If you are considering purchasing a small business it is essential
to understand the many options for financing. The majority of financing solutions are
based on the ability of the business earnings to service the debt and pay the new owner a
salary.
Before determining a financing solution you must understand the
historical earnings and current trends of the business you wish to acquire. Calculating
the true earning power of a business can be a difficult task. Most business owners maximize
tax strategies to minimize reported earnings so they pay less taxes. Therefore, when
a prospective buyer looks at the net income, or “bottom line”, of the financials they
may not be seeing the whole story. Business sellers and their advisors will often “recast”
the earnings to show the earning power of the business. This recast number is commonly
referred to as Seller’s Discretionary Earnings (SDE). SDE is calculated by “adding
back” certain expenses to the earnings:
Earnings: Net Income of the business after all expenses
+ Interest Expense: Interest is added back
assuming the new owner will pay off all liens and encumbrances of the business
+ Taxes
+ Depreciation and Amortization
+ Current Owner’s Salary
+ Current Owner’s Benefits: e.g. retirement
contributions, medical insurance, owner’s automobile
+ Nonrecurring Expenses: Large equipment
purchases or improvements that are not part of normal expenses
+ Nonoperating Expenses: Salaries or benefits
paid to the current owner’s family members who are not working in the
business
= Seller’s Discretionary
Earnings (SDE)
Once SDE is calculated you know how much cash flow is available to
service the debt associated with acquiring the business as well any salary and/or
return-on-investment you expect the business to pay you.
Lenders want to know where the cash flow is coming from to cover
the debt. They will look at the SDE of the business and first subtract the proposed
new owner’s salary to see how much remains to service the annual debt of the proposed loan.
So let’s say the business reports an annual SDE of $200,000. You indicate to the
bank that you will be taking a salary of $100,000 out of the business. That leaves
$100,000 to cover debt. The bank will divide this remaining net amount by the debt. In the
below example we will assume the annual debt is $7,000/month or $84,000/year. $100,000
divided by $84,000 in debt equals 1.19. This is called the Debt Service Coverage
Ratio.
$200,000 Seller’s Discretionary Earnings
-$100,000 New Owner’s Salary
=$100,000 Net (After New Owner’s Salary)
$100,000/$84,000 Annual Debt = 1.19 Debt Service
Coverage Ratio
Banks not only require the Net to cover the Annual Debt but to
also provide for a cushion. This cushion, or Ratio, gives the business the ability to
cover debt in the event future revenues or profits decline. Many lenders like to see a
Debt Service Coverage Ratio of 1.10 - 1.20 or higher. They also want to see that these
ratios work on the last three years of SDE and that the SDE trends in the current year
also look positive. Although lenders look at many factors in making a business
acquisition loan, if the earnings of the business will not pay the new owner a salary and
service the debt, they will not make the loan.
The Small Business Administration (SBA) guarantees billions of
dollars in loans to America’s small businesses through approved SBA lenders. Many of
these loans are made to existing businesses looking to expand. Getting approval
for a business acquisition loan is often more difficult because a new owner is
stepping in. SBA lenders have a rigorous underwriting process that will examine the buyer’s
net worth, credit history and experience in the industry. SBA underwriters are very
concerned with the ability of the new owner to run the business so communicating your
direct or indirect experience, or transferable skills, is very important.
The lender will also require a minimum injection of capital from
the buyer, typically 20% of the purchase price. Although the bank may even allow the buyer
to use borrowed money for the down payment (such as home equity), they will
include any debt related to it in the Debt Service Coverage Ratio calculation above. If this
additional debt is too high it will cause the deal to fail the Debt Service Coverage
Ratio test.
Because SBA loan requirements are complex it is best to deal with
a SBA Preferred Lender. Essentially most banks have access to SBA financing but
unfortunately very few have the experience or focus to do business acquisition loans. You
can find more information on SBA lenders at www.sba.gov or through a local business broker who knows the lenders in your area.
If the business you wish to acquire meets the Debt Service
Coverage Ratio test, and you have transferable experience, SBA financing can be an excellent
financing option. It allows the Seller to maximize the cash at closing while allowing the
Buyer to lower the down payment percentage and retain more cash for working capital.
Again, working with a SBA Preferred Lender who regularly does business
acquisition projects is essential.
Because SBA financing is complex, hard to secure and often has
high closing costs, seller financing is quite common in business acquisitions. Seller
financing has the unique ability to be as flexible as the buyer and seller need it to be
and is only limited to what the buyer and seller can agree on. The seller, like a bank, will still
be concerned about the buyer’s net worth, credit history and experience in the industry.
The seller is also likely to want a higher percentage in down payment from the buyer since a
loan on the sale of their own business is probably their only loan so they are at more
risk than a bank. Most buyers like the idea of the seller financing since it
simplifies the financing and keeps the seller vested in the businesses future success.
Sellers often prefer to cash out if they can, but the right down
payment, a more favorable price, the right buyer, sufficient buyer guarantees, security
agreements and interest earnings often ranging between 6 – 10% can generate more interest.
The terms of the financing are totally negotiable. However, a
seller and buyer would do well to consider the same Debt Service Coverage Ratio guidelines
that the SBA uses. Do the terms allow the new owner to take a salary, service the debt
and still have a “cushion”? If not, the buyer and seller have put together a deal
that will never make it to the closing table.
The buyer’s available capital for a down payment is an enormous
factor in how large of a business they can buy. Since most businesses are sold for
multiples of earnings (SDE), the more business you can afford, the more earning power it
probably has. Therefore, most buyers seek to maximize their down payment money.
Most buyers know that real estate equity, securities and savings are sources for
down payment capital. Many do not know that programs exist to use retirement funds to
start or buy a business without penalties and taxes. A business broker can refer you to
firms who specialize in these programs.
Don’t forget about working capital! When small businesses sell
they typically deliver the business free of all debts but they also keep the cash in the bank
as well as the accounts receivable. So even though you are buying a business that has
customers walking in the door on day one, you need to have enough working capital to cover
the immediate operating expenses such as payroll, supplies and rent. A retail
establishment with mostly cash sales will need much less working capital than a manufacturer
that has 30 day terms with vendors but does not get paid by customers for 60 days. Start
out by calculating the historical monthly expenses of the business and then calculate how
much working capital you need in reserves to cover these expenses.
There are many options for financing a business. A professional
business broker can assist you in understanding which ones may work for you. Remember
these important points:
1. Define the Seller’s Discretionary Earnings (SDE) of
the business
2. Subtract from the SDE what you need as a salary or
return on investment. The Net amount is what you have left to service any debt.
3. Is the seller offering financing? Do the terms
allow you to take a salary and service the debt?
4. Do you have enough down payment capital for the
size business you are looking at? Examine all sources of down payment capital. Are
your salary or return-oninvestment expectations in line with your down payment?
5. Is SBA financing available which may allow you to
leverage less money down? Do you understand all the closing costs?
6. Have you allowed for working capital?
Chris Jones is a business broker and Vice President of Sunbelt
Business Brokers of the Midwest, with offices in Minnesota, Wisconsin and Illinois.
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