By SueCanyon | September 1, 2007
Many businesses are offered for sale by the owner as ‘so-much down and so-much a month for so-long’. One of the biggest failure mechanisms for small business is buying into a business that is
1. not worth what you offer for it, and
2. doesn’t generate enough cash for you to make the payment and remain in business.
I was recently asked to look at a set of books for a company that was offered for sale for $50,000 down and another $50,000 to be paid over time. The company was a brokerage, which, from a business model standpoint, means that the cost-of-goods-sold (the place a new owner can generate profit where the previous owner wasn’t) is often out of the owner’s control. At the same time, the new owner’s strategic desires were to purchase the business, hold it for three years, then sell it for a profit. This told me that the second $50,000 had to be repaid in three years or less. I mentioned that I was concerned about the cash flow of the business. The buyer confidently exclaimed, “There’s plenty of cash flow… everything is done by credit card.” My heart sank.
Of course, I was asking, “Does the company generate enough cash to pay the new owner a decent wage, repay the purchase loan in three years, and still have enough left over to run the business?” Additionally, it should generate enough return on the original investment to exceed what he would have made had he invested that cash into another investment such as a money market account, or at least 10% per year.
It was immediately apparent to me that this was probably not the case. First of all, 10% on the original investment of $50,000 is $5,000, which doesn’t consider a return on the investment of the other 50 grand. Next, the $50,000 note still due divided by three years equals about $16,700 per year, not including the interest that will be due on the note. The new owner wanted to earn a modest paycheck of only $24,000 per year. Added together, this business needed to produce a minimum of $45,700 in profit to generate enough cash to run the business (this assumes no capital expenditures). You’ll want to figure income tax for a business on top of that.
Any company that you can purchase for $100,000 that offers a return of nearly half of that per year is either seriously under-priced or there is something gravely wrong with the model, which I will discuss below.
Another factor about which to pay attention when looking to buy a company is whether you are going to absorb any of the other debt of the company, for instance the payment on equipment or a business loan. Remember that the principal portion of the payments on company loans are not posted to the P&L, so you must add them to the profit figure to determine the amount of cash that must be generated by the business in addition to that which it needs to continue operations.
One of the ways in which brokers will “help” you determine how much cash the company might generate is by showing “add-backs”. Add-backs are those monies that the owner may have been spending that you might not need or want to spend. For instance, if the mother-in-law who doesn’t actually work for the company has been taking a paycheck, the amount paid to her would be an add-back. But if you were going to hire your mother-in-law, spouse, or sibling in the same manner, then don’t consider it as an add-back.
The problem with many of the add-backs that brokers will show, is that the costs are for items that you will need to replace in order to keep the business running. They will often add back the pay that the seller is taking out of the company. Well, if the seller is taking a paycheck of $125,000 a year, and you planned to take only $25,000, then you can allow $100,000 to be added back. But if you expect to take $125,000, then this should not be considered an add-back.
Brokers legitimately do this because they have no way of knowing how much you will charge the company for your services, and there is great variability from one company to another as to how much the seller is paying themselves. Analyzing costs in this way helps to even the playing field. However, the effort tends to take advantage of the less knowledgeable business buyer.
If the previous owners were paying for a truck which they expect to take with them, then the payment for that truck might be an add-back only if you already have a vehicle that you are bringing to the business that has no debt associated with it, and you are not planning to replace it within the next few years. Otherwise, it’s not an add-back because you will need a vehicle. So, be very careful to not allow the broker to convince you that a business is profitable given add-backs that shouldn’t have been.
One more add-back to watch carefully is depreciation. Brokers will always add this back because it is a non-cash item. This is true. However, unless all the equipment is brand new, and you can afford to not replace any of it for a period of five years, then you will have to spend cash for equipment as you go along, just as the previous owner did. While the depreciation figure is somewhat arbitrary, it is a truer indication of the cash expenditures that will be necessary in the future to keep a business healthy than if you simply stopped buying equipment.
For example: A broker offers a business that ‘cash flows’ $1,000,000, of which $600,000 is depreciation and $125,000 is owner pay. There was $75,000 in taxes on $225,000 in profit. Working from the $1,000,000 in cash flow, the buyer negotiates a payment for the business of $1,000,000 down (financed) and $20,000 per month for five years. He feels he can live on $125,000 per year, plus he needs to earn enough to make these two payments every month. The total of the purchase payments will exceed $400,000 per year for five years.
This is a great deal for the seller, who will quickly spend his $1,000,000, then will expect to live on the $20,000 a month as he begins to set up his retirement. For the buyer, however, things are not so great.
You’ll notice that the cash outflow, just to make the payments on the business, exceeds the cash generation ability of the company by $250,000 per year. Something has to give, so the $600,000 in equipment purchases that the company enjoyed for the last few years, will now be cut down to $350,000 per year for at least five years. Since equipment purchases are often financed, and the new owner is financed to the hilt, there is little room to purchase any new equipment. After about eighteen months of needing equipment he can’t get, operations begins to falter, quality suffers, and customers begin to go elsewhere.
Then comes the day when he has to skip a payment to the seller. Suddenly, the seller’s life is thrown into turmoil. He has been living like a king, living like he thought he should have been able to when he went into business in the first place, but was never able to. He calls his lawyer and begins the inevitable suit. The new owner loses, it costs both of them dearly, and the business is worth far less than it was when it was sold. The ultimate result is tragic.
In addition to the concerns expressed above, any changes that a buyer might want to make which may include adding functions or equipment to make the operation more efficient, will be affected and must be considered in cash flow calculations. Any changes that will improve the cost figures may also improve the profits and cash flows of the business and must also be considered. However, never underestimate the negative impact new ownership may have on sales of the product and on employee turnover.
When I was ultimately shown the balance sheet and the income statement (or P&L) for the brokerage business, I immediately saw several problems. First of all, the retained earnings reported on the balance sheet was a negative number. This indicates that the company had not made more money than it had lost in all the years it had been in business. So, basically, without a great deal of equipment or inventory, the true value of this business was less than zero. Without profit, it would not be able to generate enough cash to run, let alone achieve the new owner’s objectives.
Second, nearly all the direct costs were in subcontractor fees which are dictated by the market, therefore there was very little room for cost reduction. And third, having been told that they did all of their transactions by credit card, their credit card fees did not come close to reflecting what one might expect to be spent at the revenue level they were reporting. That made me suspicious of the revenue figures as it was unlikely that much of their revenue could have come in the form of cash or checks. Bank transfers were likely, but then again, they would have cost even more than the credit cards would have.
Fourth, they reported no costs for an office. The buyer would have had to rent a modest office, and this would have had to be added to the costs, which would necessarily add to the amount of cash required to run the business.
In this case, I could see no winning for anyone but the seller, who would, at the very least, realize $50,000 from the business. This was far more than it was worth. Once a payment was skipped on the second $50,000, the sellers would then be allowed to sue for the balance of the sales contract even though the company was seriously over priced. My clients wisely chose not to buy the company.
Another client was not so lucky. I met them long after the purchase deal was completed and the buyers had been in business for more than a year. However, the payments on the purchase loan were clearly eating so far into the cash flow that, had they continued to make the full payments, they would not have been able to pay their vendors in an industry that was closely regulated by the state.
After running a detailed cash flow analysis on this company, it became clear that if they paid half the payment, they would be able to remain in business. In this particular case, the client decided that, at the cost of half the payment, they would still be able to finish paying the loan within twelve months, and that it was unlikely that a possible court action by the sellers would take less time than that.
The gamble was successful. The sellers did sue, and the final hearing date happened to coincide with the buyers making the last payment including the extra interest that was due. The sellers then had no recourse, except possibly to collect attorney fees. This result was one of the better ones I’ve seen.
Quite often, a buyer will agree to “pay out of cash flow”, but the buyer doesn’t understand the figures used to determine what payment might reasonably work. This is especially true when the transaction involves family members or friends of the seller.
The last thing I have to caution about when looking at the books of a company offered for sale is that a very high percentage of business owners don’t have proper figures in their books, the seller doesn’t know how to evaluate his own books, and the buyer doesn’t know how to read the figures. If you can’t rely on the figures that are presented to you, or don’t know what the figures mean, then it will be impossible to figure your cash flow with enough certainty to offer the buyer a deal you can live with.
The subject of proper figures is one that is far too deep for a discussion on purchasing a business. You can learn much more about that subject in the Profit Power Action Pack Lessons if you like.
Occasionally, I can spend the time to evaluate a set of books for someone for a fee. Anyone who is interested can contact me at firstname.lastname@example.org.
Good luck, and look for more information on purchasing a business in future articles.
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