How to use Accounts Receivable Financing in an Acquisition of a Business.
012-2005
Considering buying your
competitor? Unless you have been in business for ten years and
established an incredible track record of strong profit and cash flow,
have lots of equity on your balance sheet, or have a seller willing to
tote the note for you, you will likely be seeking some type of creative
financing. In the following pages, we will assume you already have a
business, that you have good-quality, unencumbered accounts receivable
in your existing business, and that you are seeking to acquire another
company.
The fact is, most sellers of businesses want all or a good chunk of the
sales price up front. Some sellers may finance a small portion of the
sales price for you. Often, sellers want to sell their companies at
multiples of book value, cash flow, revenues, net income, or all of the
above. The value of a business over and above the book value of the
tangible assets is known as goodwill. The more goodwill, the more
difficult it is to finance by conventional means.
Nearly every seller of a business thinks their business has more
goodwill than everyone else. It’s called human nature. Naturally, you
build a business, put in all the sweat equity and the long hours to get
to a point where the business has value. Now you want to cash out and
you want someone to pay for what’s dear to you.
The most common items making up goodwill include accounts (the customer
list), trade marks and trade names. Consider that a fast food operator
who hangs a “KFC” sign in front of his store is sure to attract more
business than his neighbor who hangs a sign, “Jack’s Fried Chicken”.
Assuming Jack’s chicken is as good as the colonel’s, the difference in
their sales is attributable to goodwill associated with the trade name,
“KFC”. KFC franchisees pay a royalty to the colonel for bringing in all
those customers.
Likely, a company you acquire won’t have the kind of name recognition
that KFC enjoys, so you can’t justify paying an excessive premium for
the name. The name may have some value, but besides the equity in the
assets you are purchasing, most of the goodwill lies in the customer
relationships or in the assets’ ability to generate above-market ROA
(return on assets).
When purchasing the assets of a company, the accounts or customer list
will probably be included in the acquisition. The value of that customer
list can only be determined with time. This is what makes business
valuation so difficult. There are several variables that affect the
value of the customer list. Customer retention after an acquisition is
key. Following are some questions to consider:
1. Are you going to retain the owner and/or old sales staff of the old
business that had the primary relationships with the customers or are
they going to defect and take all their customers with them?
2. Can you enforce a
non-compete against the old owner and can you get the old sales persons
to sign one?
3. Are you prepared to pay
the old sales persons a “stay on” bonus in order to get them to sign a
non-compete agreement?
4. Will your competitors use
aggressive tactics and use the sale of the company as a reason for the
customers to switch to your competitor?
5. Are the customers
contractually bound to continue doing business with you?
Generally speaking a
buy/sell agreement will contain a non-compete provision that the old
owner will have to sign. But you cannot control the other variables.
The prudent solution is not to pay more than book value for the assets
at the time of closing and to pay for goodwill, if any, over time in the
form of a royalty or monthly installment tied to revenues generated by
the accounts existing at the time of closing.
Bear in mind, the seller has the very reasonable expectation that you
will work hard to maximize the value of the customer list by providing
excellent service and pricing if you expect the seller to accept part of
the sales in deferred or installment payments tied to future revenues.
Some negotiating skills are required.
If your acquisition target’s primary assets are receivables, and the
seller is demanding a cash payment, you have a dilemma. Try to structure
an asset acquisition without the accounts receivable or, if you are
buying the existing accounts receivable, do not pay cash for them and
set aside a reserve for uncollectible accounts from the proceeds in
escrow until all pre-closing accounts receivable are collected.
If the existing accounts receivable are included in the sale, the seller
should give you credit towards the purchase price for any collections he
receives which relate to the pre-closing receivables or credit for any
uncollectible accounts after a pre-determined number of days. This can
be done through use of an escrow as described in the preceding paragraph
or as a credit.
Let’s look at a simple example:
Assume you want to buy a business reporting the following:
Cash:
$ 5,000
Accounts Receivable:
$100,000
Inventory
$ 25,000
Equipment (net of depn)
$100,000
Machinery (net of depn)
$ 60,000
Vehicles (net of depn)
$ 50,000
Goodwill
$160,000
Total Assets
$500,000
Liabilities
Accounts Payable
$ 40,000
Notes Payable
$160,000
Total Liabilities
$200,000
Net Worth (Equity)
$300,000
Tangible Net Worth
$140,000
Annual Sales
$1,200,000
Net Income
$ 100,000
Assume the seller is asking
$500,000 for all the assets, including the accounts receivable. That
would be a premium of $160,000 over and above the tangible book value of
the assets. Now there are two important questions. Is this company worth
such a premium and if so, how do you structure payment to minimize your
risk.
Here’s a model:
Cash down payment of
verifiable tangible assets minus accounts receivable
= $240,000
Owner Collects the
pre-closing accounts receivable over the 30-60 days following
closing
= $100,000
Goodwill paid in 48
monthly installments equal to 3.3% of monthly revenues, not to
exceed $160,000
= $160,000
Total Sales Price
= $600,000
Is $500,00 a fair price for these assets? You may want to consider other
business valuation measures:
$500,000 is:
<.5% of annual sales
= 6 times earnings
=150% of market value of tangible assets
For simplicity sake, we have ignored other capital requirements, such as
the debt and equity that the old company carried on its books to finance
these assets. Consulting an experienced accountant and lawyer are
critical at this stage.
Now, you might consider factoring your own company’s accounts receivable
to come up with the $240,000, then continue factoring both companies’
accounts receivable in combination with some traditional equipment
financing (i.e. leasing, or borrowing) to satisfy your ongoing working
capital requirements. Over time, if you are profitable, you should be
able to retain enough earnings to wean yourself off factoring or
otherwise qualify for a bank line of credit at a later date.
Do not structure the purchase to include a cash purchase of the
pre-closing accounts receivable without the personal guaranty of the
owner that they are 100% collectible. Even if you verify 100% of the
accounts receivable, you are subject to many risks if you buy those
receivables. Risks include later-discovered fraud, disputes with
customers, credits, returns, and other dilutive variables. There are
also practical and legal issues concerning how the customers are
notified of a change in remittance instructions. Anything short of 100%
collectibility of the accounts receivable by the buyer within 60 to 90
days post closing should be credited against the purchase price in some
fashion.
If you feel that this type
of financing is right for your business acquisition, please call today at 1800 450
9653.
1st Commercial
Credit, a
nationwide
factoring company headquartered in El Paso, Texas. Provides accounts
receivable financing in the US, Canada, and the UK; offers
export trade finance to clients in every major world
market and can convert receivable finance transactions in 17
currencies.
1st Commercial Credit is a
factoring company that provides receivable financing for all major industries, We are
always adding industries to our portfolio.
[
[
[