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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.
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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:
- 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?
- Can you enforce a non-compete against the old owner and can you get the old sales persons to sign one?
- Are you prepared to pay the old sales persons a “stay on” bonus in order to get them to sign a non-compete agreement?
- Will your competitors use aggressive tactics and use the sale of the company as a reason for the customers to switch to your competitor?
- 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
- 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:
- <.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.