Reducing Cost of Capital in a Small Business Acquisition

Small Business Administration (SBA) guaranteed loans are widely recognized as one of the only reliable sources of third-party funding for small privately-held business acquisitions (up to $5 million), but do you know how this benefits the borrower’s cost of capital?

Very few small business transactions are completed in which the buyer pays all cash. This is not just because most people don’t have a big pile of cash lying around; it’s also because financial leverage lowers the overall cost of capital in any investment where an income stream is expected. And every business broker knows that it also allows a buyer to purchase a larger, more profitable business.

SBA debt financing for business acquisitions currently “costs” around 6% (interest). The cost of equity financing is much higher — typically 20 to 25% or more — depending upon the risk level of the investment. The risk is much higher for the portion not financed by SBA because if cash flow from operations declines for any reason, it’s the buyer’s cash flow (and return on equity investment) that suffers. The greater the risk, the greater a rational buyer’s expected rate of return will be. In other words, an equity holder’s cash flows are riskier than a bank’s, so they require a higher rate of return. Also, in the event of a liquidation, the debt holder has preference.

How is cost of capital calculated?

If a buyer is able to obtain 6% money from the SBA on 70% of the purchase price of a $1,000,000 business acquisition, and the buyer expects a rate of return of 25% on the remaining 30% (equity portion of capital structure), the weighted average cost of capital is:

Debt               70% x 6%    =   4.2%

Equity            30% x 25%  =   7.5%

Weighted Average Cost of Capital   =  11.7%

This means that by leveraging the business acquisition, the buyer will see greater rates of return from the profits generated; not a bad reason to “leverage the deal.”

By the way, what amount of Fair Market Value will an SBA lender lend?

Subject to the buyer’s qualifications (of course), SBA lenders typically loan 70% (more in certain cases) of an agreed upon asset sale/purchase price plus an amount for working capital (lenders call it “over-funding” the loan). SBA regulations for 7(a) loans require that the sponsoring bank obtain an independent business appraisal from a qualified appraiser for any loan with an intangible (goodwill) value component over $250,000; or for any amount when the business is being sold to a family member. This is a great check and balance for the buyer to be sure the business isn’t over-valued.

When the appraised fair market value of the business comes in below the agreed upon purchase price, the SBA lender can still lend, but only up to 70% of the appraised Fair Market Value. Here the buyer is usually faced with two choices: (1) pay the incremental amount over the appraised value and increase their cost of capital; or (2) re-negotiate with the seller to lower the price.

“The Importance of a Proper Valuation” is the subject of my next Blog … so stay tuned.

Bob Altieri, CBA (Certified Business Appraiser) appraises businesses for SBA lenders throughout California. For additional information or for advice on a current need, please do not hesitate to call Bob. 

Do Strategic Buyers Share Synergies with Sellers?

In successful M&A deals involving substantial synergies, the deal price usually falls in the range between the standalone fair market value of the target business and that value plus the full value of potential synergies.

Value of potential synergies?
Increased value (over and above fair market value) to a strategic buyer, involves synergies between the acquired and acquiring firm and the additional financial returns and therefore value created by those synergies . There is a “1+1=3” effect in the acquisition process. Synergies come in various forms, including an ability to increase revenues of the target firm, cost savings by eliminating redundancies or achieving economies of scale through combining of business units; and the reduction of risk through, for example, increased size and stability, greater management depth or vertical integration.

How much of this synergistic value component is paid in practice?strategic value_2

Buyers pay, on average, 31% of the average capitalized value of expected synergies to sellers, according to recent research by the Boston Consulting Group. The March 2013 BCG article, titled “How Successful M&A Deals Split the Synergies”, can be viewed here.

From an acquirer perspective, why pay for synergies at all?

Because sellers usually anticipate buyers’ synergies and demand to be paid something for them, particularly when multiple strategic buyers are present. In addition, when the buyer is a public company , markets usually react favorably and boost the value of the acquirer when a strategic acquisition is announced. Of course, this increase in value may vanish if the synergies don’t actually materialize! When paying more than fair market value, strategic acquirers must be certain that there will be synergies in the combination. They do not randomly shell out big bucks. The owners of firms that appeal to strategic buyers have a greater opportunity to maximize value in an M&A sale process.

However, not every firm is a strong candidate for a strategic sale.

Most willing buyers for small companies are financial buyers who will operate the business similarly to the way it is operating now, and are normally willing to acquire a company for fair market value. Individual owner-operators, management employees and private equity buyers are examples of financial buyers.

We are always happy to discuss how buyers would typically value of your company. Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.

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Exit Fundamentals: Two ways to Sell a Business

This article introduces the two fundamental methods of transferring a 100% interest in a private business, a) an “Asset Sale” and b) a “Stock Sale”. Asset Sales account for more than 90% of small business transactions. By small I am thinking of businesses with up to $10 million in revenue.

Asset Sales

In an Asset Sale the seller sells all of the tangible and intangible assets of the business, and ends up retaining the legal entity, which the seller then winds down (or uses for another business purpose). The seller terminates the employees (and pays out any accrued vacation), and the buyer typically rehires substantially all of them. In effect, the buyer starts a new business using the assets purchased from the seller.  When the buyer is a complementary or competing business, an asset sale often involves less than the seller’s entire basket of assets.

A company’s basket of assets typically includes: cash and equivalents, accounts receivable, inventory, work in process, deposits, equipment, trade fixtures, leasehold, leasehold improvements, contracts, business records, software and software licenses, licenses and permits, franchises, covenant not to compete, trade secrets, patents, intellectual property, trade name, customer lists, marketing materials, telephone numbers, web sites, URL’s, email addresses, sales order backlog and goodwill.

Leases and other contracts are assigned to the buyer, and certain liabilities may be assumed by the buyer. Often, the seller keeps any cash and deposits and pays off all liabilities of the business, delivering title to the assets free and clear of all liabilities.

Stock Sales

If the business is a corporation (or other legal entity) then the individual who owns the shares in the corporation can sell their shares to a buyer.  This is a stock sale.  The buyer buys the entire balance sheet.  Debt remaining on the balance sheet is usually considered part of the payment of the purchase price.  The most recent balance sheet or a target balance sheet is attached to the purchase offer (usually a letter of intent or LOI) and there is language in the offer that adjusts the price for any changes in net working capital or debt that occur between the LOI signing and the transaction closing.

Asset Sale Pro’s and Con’s

There are several advantages and disadvantages to the parties in an asset sale (versus a stock sale). Here are some of them:

BUYER□     “Step Up” in basis for depreciation and amortization

□     Free of most contingent liabilities

□     Can select assets to purchase

□     Can change entity type, state of registration

□     Due diligence less extensive

□     Transaction more complex

□     Lose non-transferable rights

□     Unable to carry over tax losses, if any

□     Have to reestablish credit, licenses, permits, etc.

□     Require consents to assign contracts

SELLER□     Retain corporate entity

□     Can keep certain assets (e.g. patents)

□     Usually higher price

□     Double taxation (C Corp’s)

□     Depreciation recapture

□     Transaction more complex

Buyers usually want to buy assets for two reasons:

1)     They can write up the value of depreciable assets and depreciate them again, and amortize all of the goodwill value, and

2)     They avoid any liabilities that might arise after closing that were caused by events that occurred before the transfer of ownership.  Stock sale terms usually include the seller holding harmless and indemnifying the buyer against undisclosed or contingent liabilities, but what if the seller has already spent the money or refuses to pay! Of course you would do that, but that’s what worries buyers.

For the owner of a “C” corporation an asset sale (versus stock sale) normally has a far less favorable tax treatment.  If you own a C Corporation, you should talk to your CPA about converting it to an S Corp.

This is a very basic introduction to this topic, and don’t take this as legal or tax advice. In addition to a broker/M&A advisor, you must always have experienced legal and tax experts on any transaction team and in any exit planning process. To discuss your circumstances, feel free to give us a call.

Glossary of Business Sale, Merger & Acquisition Terms

As with most industries, the M&A industry has its own terminology, which can be confusing to the occasional transaction participant. Here we present many of these terms so that you can have a better understanding and comfort level when we discuss the potential sale of your company. Many of these terms are accounting, finance or legal in nature.

Accrual Method of Accounting:  A method of accounting wherein income and expenses are recognized on the financial statements when the business first acquires the right to receive the income (even though payment may not yet be received) or the obligation to pay the expense (even though payment may not yet be remitted). Most C Corporations are required to use the accrual method of accounting. Investors and lenders will generally want to see accrual statements.

Add-Backs:  Adjustments to the normalized income statement that are made in order to give a more accurate picture of a company’s earnings, which generally include (a) non-recurring expenses, such as the cost of moving the plant, and (b) owner perquisites such as non-business travel and entertainment. Add-backs are some of the adjustments made to arrive at normalized cash flow, EBIT, EBITDA and SDE.  All add-backs should be verifiable, as they will eventually be subject to scrutiny by buyers and their advisors, and lenders.

Allocation of Purchase Price: In an asset sale, the purchase price must be allocated to tangible and intangible assets and goodwill. The buyer and seller agree on and report the same purchase price allocation to tax authorities (IRS form 8594). Different price allocations will have different tax implications for the buyer and seller, and their interests are not always aligned. You must obtain advice from your tax advisor.

Amortization:  The periodic write-off of the cost of an intangible asset over its estimated useful life. The amortization concept is equivalent to depreciation of tangible assets.

Angel Investor:  A high-risk investor who invests in promising early-stage companies. Angels often have valuable business experience and can also serve as advisors and/or board members to the company.

Appraisal:  See Valuation.

Asset Approach to Valuation: A general way of determining a value indication of a business by using one or more methods based on the value of the assets of that business net of liabilities.

Asset-Based Lenders:  Commercial lenders who are willing to take on more risk than commercial banks; lending against fixed assets, accounts receivable and inventory and being subordinate to commercial banks.

Asset Sale:   A sale/purchase of certain (usually most or all) business assets that are both tangible and intangible in nature, and often some liabilities, leaving the seller with the corporate entity and possibly some remaining assets and liabilities. This type of sale significantly reduces the possible liability of a business purchaser, usually has tax benefits to the buyer, and may increase the time it takes to close a deal.  Asset sales account for a majority of business sale/purchase transactions.

Auction Process:  When a business intermediary orchestrates the selling process by encouraging buyers to bid until the best offer is received.

Balance Sheet:  A statement of the financial status of a business on a certain date. Also called the statement of financial condition, it summarizes a company’s assets, liabilities, and owners’ equity.

Blue-Sky:  That portion of a claimed value or requested price that cannot be supported or shown to exist through the application of recognized business valuation methods. (Blue sky is not the same as goodwill)

Book Value:  That figure derived by deducting balance sheet liabilities from assets.

Bridge Loan:  A temporary loan to cover the financing shortfall of the acquisition until permanent funding is available.

Bulk Sale: A law that regulates the transfer of business assets to prevent sellers from receiving sale proceeds before creditors are paid. If a business owner wants to conduct a bulk sale of business assets — that is, sell an unusually large amount of inventory, merchandise or equipment — the business owner must publish a notice of bulk sale and give written notice to creditors. Then, the owner must set up an account to hold the funds from the sale for a brief period during which creditors may make claims against the money. The prohibition against bulk sales is spelled out in the Uniform Commercial Code — and laws modeled on the UCC have been generally adopted throughout the country. The California bulk sale law is contained in division 6 of the Commercial Code and is significantly different from the UCC version.

C Corporation:  A corporation whose profits are taxed separate from its owners under subchapter C of the Internal Revenue Code (versus an S corporation, whose profits are passed through to shareholders and taxed on their personal returns under subchapter S of the Internal Revenue Code).

CapEx:  An abbreviation of Capital Expenditure.

Capital Expenditure:  An amount spent (often during a particular period, say annually) to acquire or improve long-term assets such as property, plant and equipment.

Cash Basis Accounting:  A method of accounting wherein income and expenses are recognized (on the financial statements) when the business receives the income or pays an expense.

Capitalize:  To classify a cost as a long-term investment, rather than expensing it to current operations. A capitalized cost does not appear on the income statement, but instead appears as a credit on the long-term assets account and a debit on the cash account of the balance sheet. However, the depreciation expense related to the capitalized cost will appear as an expense on the income statement. Since the long-term assets account is larger due to the effect of capitalization, the depreciation costs are also proportionately larger. Thus, the timing of expense recognition is changed, but eventually all capitalized expenses do get recognized on the income statement.

Capitalization:  A conversion of a single period stream of benefits into value.

Capitalization Rate:  A divisor (usually expressed as a percentage) used to convert earnings or cash flows into value as part of the capitalization process.

Cash Flow: Cash that is generated over a period of time by a business enterprise. There are many types of cash flow. When the term is used, it should be supplemented by a qualifier (e.g. “discretionary” or “operating”) and a more specific definition. The definition should state, for example, whether the cash flow calculated is that available to debt and equity holders (pre-debt), or just equity holders (after debt service). See Net Cash Flow.

Certified Business Intermediary (CBI):  A professional designation granted by the International Business Brokers Association (IBBA). CBI’s must complete extensive training, maintain high ethical standards, stay current on industry trends and information, and demonstrate success as business intermediaries. This certification is highly regarded in the M&A community and by transaction professionals.

Closely Held Corporation:  A corporation whose stock is owned by one or a few shareholders and is operated by this person or close knit group.

Collateral:  Property pledged by a borrower to guarantee payment of a debt. Bank loans are usually collateralized or secured by the company’s accounts receivable, inventory and equipment, and frequently by some secondary source of repayment.

Confidential Business Review (CBR):   A document containing a detailed analysis and narrative description of a business and its future prospects. Often called a “Deal Book” or “Offering Memorandum”.

Confidentiality Agreement:  A document signed by potential buyers that requires them to keep the information contained in the CBR and M&A discussions completely confidential. This document is signed BEFORE the CBR is provided.

Contingent Liability:  (a) A possible obligation from past events that will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the business; or (b) A present obligation from past events but is not recognized because (i) it is not probable that an outflow of resources will be required to settle the obligation; or (ii) the obligation cannot be measured reliably. Some examples: in corporate reports are pending lawsuits, judgments under appeal, disputed claims, and the like, representing potential financial liability.

Covenant:  A binding agreement between buyer and seller that restricts each party from taking certain actions, particularly during the Letter of Intent period and closing

Depreciation:  The allocation of the cost of a tangible asset to expenses over the asset’s estimated useful life.

Discount Rate: A rate of return (cost of capital) used to convert a monetary sum, payable or receivable in the future, into present value.

Discounted Cash Flow (DCF):  A valuation model that assigns a value, in today’s dollars, to the discrete cash inflows and outflows that are reasonably expected to occur during future periods. DCF considers risk and the time value of money.

Due Diligence:  The investigation of the business (and buyer) in an attempt to verify information given or uncover previously unknown information.

Earn-Out:  A contract provision stating that the seller is to be paid some amount of consideration based on the business achieving certain financial metrics (usually sales or profit-related) in the future. Two situations in which earn outs are often negotiated are (a) a high percentage of business is with a few customers, and (b) valuation is based on significant sales and earnings growth, for example due to a new product introduction.

EBIT:  Acronym for Earnings Before Interest and Taxes. The earnings remaining after cost of goods sold, and all selling, general, and administrative expenses (SG&A), but before interest and taxes. EBIT is normally calculated and presented on a normalized basis, where one carefully identifies and adjusts for non-operating and nonrecurring income and expense. See also, Seller Discretionary Earnings. Add-Backs and EBITDA.

EBITDA:  Acronym for Earnings Before Interest, Taxes, Depreciation and Amortization.  EBITDA is a very common M&A term, but should always be just a starting point for discussion regarding financial performance. EBIT and cash flow are more realistic metrics than EBITDA because they account for (historical or projected) capital expenditures.

Escrow Holder:  A neutral third-party that prepares routine financial, compliance and legal documents related to the transfer of a business and holds funds until the parties fulfill specified conditions.

Executive Summary:  A 1-page profile of a business that is used to solicit buyer interest. It is usually a “blind” synopsis of the CBR, with all identifying information removed. This is also called a “teaser”.

FIFO:  Acronym for the First In, First Out inventory valuation method. The first inventory units purchased are considered to be the first sold. Therefore the cost of the inventory would be based on the most recent units purchased. The end result of this method (in an inflationary cost environment) is that the ending inventory value is higher, and therefore cost of goods sold is lower, which in turn makes gross profit and net profit greater. The opposite would be true if purchase costs were declining over time. See LIFO.

Fair Market Value:  The amount that a hypothetical willing buyer would pay a willing seller acting at arm’s length in an open and unrestricted market, when neither is under any compulsion to buy or sell, and when both have reasonable knowledge of the relevant facts.

Financial Buyer:  A buyer that values a business based on the expected future economic performance of that business if operated on a standalone basis (without additional synergistic benefits). Financial buyers are typically willing to pay fair market value. Individual owner/operators, management employees and most private equity buyers are examples of financial buyers.

Floor Price:  The lowest preconceived price a seller will or should accept.

Form 4506:  A form often required by an acquisition financing lender to obtain copies of federal tax returns (of the seller and buyer) from the IRS for verification purposes.

Free Cash Flow:  Free cash flow is usually calculated as net operating income plus depreciation and amortization (non-cash charges), less capital expenditures, plus/minus changes in net working capital. Free cash flow, in essence, is the amount of cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is what allows a company to pay dividends, reduce debt and pursue opportunities that enhance shareholder value, such as develop new products or make acquisitions.

GAAP:  Acronym for Generally Accepted Accounting Principles. GAAP includes the standards, conventions, and rules accountants follow in recording financial transactions and preparing financial statements. GAAP comes from the Financial Accounting Standards Board (FASB), a non-profit organization created by the accounting profession to develop and maintain standards.  GAAP is slowly being phased out in favor of the International Financial Reporting Standards (IFRS).

Going Concern Value:  The value of a business enterprise that is expected to continue operating in the future.  The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, a customer base and suppliers, and the necessary products, systems and procedures in place.

Goodwill:  Generally means the difference between the purchase price and the value of the assets of an acquired business.

Holdback Provision:  As written into a purchase agreement, this provides for an amount to be held in escrow for a period of time after closing, often to pay any liabilities that the seller may not have disclosed, or to provide incentive for a seller to complete a promised act after the closing and change-of-possession.

Income Approach:  A way of determining a value indication of a business using one or more methods that convert anticipated economic benefits into a present single amount.

Installment Method:  A method of accounting under which gains are recognized as payments are received.

Indemnification:  Usually the exemption for the buyer from incurred penalties or liabilities after the closing from incomplete representations and warranties of the seller.

Intangible Assets:  Non-physical assets (such as franchises, trademarks, patents, copyrights, goodwill, mineral rights, securities and contracts), as distinguished from physical assets, that grant rights, privileges, and have economic benefits for the owner.

Investment Banker:  A business intermediary for Middle-Market companies who sometimes provides additional services such as bridge loans or underwritings. For Main Street and lower Middle Market transactions this person is usually known as a business intermediary, M&A advisor, or business broker.

Lease Assignment:  When selling a business that occupies leased premises, a buyer typically “assumes” the lease.  Commercial leases are personal property and belong to the business or its owner, who is the tenant. A tenant (seller) may assign his “right, title and interest” in that lease to an “assignee” (buyer).  The act of assignment does not relieve the original tenant, or “assignor” from his obligations under the lease unless the landlord specifically releases him.  It is unusual for a landlord to release an assignor, but the tradeoff is that it makes it easier for a landlord to consent to an assignment. Typical lease language states that the lease is assignable with landlord’s consent, sometimes “not to be unreasonably withheld”.  Some leases can not be assigned.  Some require the tenant to pay the landlord a fee to consider an assignment of the lease.

Lehman Formula:  An industry standard commission rate, which is a sliding scale percent on successive million dollar purchase price brackets.

Letter of Intent:  A written offer to purchase a business, usually non-binding, which if accepted by the seller leads to due diligence and the drafting of a definitive Purchase and Sale Agreement.

Leveraged Buyout:  A transaction in which a company’s capital stock or its assets are purchased with borrowed money, causing the company’s new capital structure to be primarily debt. Management Buyouts are generally leveraged buyouts.

Lien:  A charge or hold on assets usually by a creditor until the indebtedness is satisfied.

LIFO:  Acronym for the Last In, First Out inventory valuation method. The last inventory units purchased are considered to be the first sold. Therefore the cost of the inventory would be based on the earliest purchased cost. The end result of this inventory method (in an inflationary cost environment) is that the ending inventory value is lower, and therefore cost of goods sold is higher, which in turn makes gross profit and net profit lower. The opposite would be true if purchase costs were declining over time. See FIFO.

Main Street Businesses:  Generally defines firms with revenues below $5 million. See Middle Market. Our firm generally sells Main Street and lower Middle Market companies, with revenues from $1 million to about $30 million.

Market Approach:  A way of determining a value indication of a business using one or more methods that compare relevant characteristics of the subject firm to similar businesses that have sold.

Market Cap:  Abbreviation of “market capitalization” that applies to a public company’s worth in the stock market by multiplying the total number of shares outstanding by the current stock price.

Mezzanine Capital:  Subordinated to senior debt, it is like a second mortgage, with higher interest rates and often with common stock purchase warrants.

Net Cash Flow: A form of cash flow. When the term is used, it should be supplemented by a qualifier (for example, “Equity” or “Invested Capital”) and a definition of exactly what it means in the given context.

Net Cash Flow to Equity: Those cash flows available to pay out to equity holders (in the form of dividends) after funding operations of the business enterprise, making necessary capital investments, and reflecting increases or decreases in debt financing.

Net Cash Flow to Invested Capital:  Those cash flows available to pay out to equity holders (in the form of dividends) and debt investors (in the form of principal and interest) after funding operations of the business enterprise and making necessary capital investments.

Net Worth:  See book value.  Net worth in M&A is often based on the value of assets and liabilities at their true (market) value, not necessarily as expressed on the balance sheet, and may include the value of intangibles and goodwill not shown on the balance sheet.

Niche:  Uniqueness in the marketplace in which the company has a product or service, which has a competitive advantage because there are few competitors.

Non-Operating Assets: Assets not necessary to ongoing operations of the business enterprise.

Normalization:  Business valuation usually requires adjusting or “normalizing” financial statements to remove the influence of decisions made by the owners to minimize taxes; and to recast or restate them in such a way as to depict the economic performance and condition of the company from the perspective of an investor who would consider purchasing the company. Normalizing usually involves marking assets and liabilities to market and adjusting financial statements for non-operating assets/liabilities; discretionary, related-party, non-market, nonrecurring and non-operating income and expenses; and accounting irregularities, to depict true business economics and facilitate buyer analysis. Business intermediaries and appraisers normalize income statements using standard methodologies.

Normalized Earnings:  Company earnings after the normalization process described above. Normalized earnings are commonly stated at the SDE, EBITDA and EBIT levels.

Off Balance Sheet Liabilities:  Unrecorded obligations, such as repurchase agreements, pending lawsuits, and unfunded pensions.

PEG:  Acronym for Private Equity Group.

Perquisites (Perks):  Owner benefits incidental to a regular salary or dividends, such as personal use of a company automobile, country club membership, and personal entertainment.

Preferred Lender: A lending institution that has met the Small Business Administration’s necessary experience and quality requirements is given “preferred” status, and is allowed to make lending decisions on behalf of the SBA. Working with a Preferred lender can save 30 days in closing a deal.

Price Multiple:  The inverse of a capitalization rate.

Recasting:  See normalization.

Representations and Warranties:  Statements made in a contract by either party that refer to past or present facts or matters that are important to the contract. The contract may then go on to provide that if a party is wrong about a representation or warranty, that the other party has certain remedies available to him or her. Each party must stand behind its representations or pay the price for breaching them.

ROI / ROE:  Acronyms for Return on Investment and Return on Equity. Must be greater than the cost of capital in order to create shareholder value.

S Corporation:  Common business slang to distinguish a corporation whose profits are passed through to shareholders (without a corporate level tax imposed) and taxed on their personal returns under subchapter S of the Internal Revenue Code. An S corporation has restrictions with respect to stock ownership, such as it must be owned by thirty-five or fewer individuals.

SBA (Small Business Administration): A federal agency, created in 1953, that grants or guarantees long-term loans to small businesses.

SBA Loan:  Loans made to buyers of small businesses by banks or other qualified financial institutions and guaranteed by the Small Business Administration of the U.S. Government.  These loans usually have terms of 7 to 10 years, variable interest rates, and monthly payments starting 1 month after closing.  SBA Lenders require sufficient earnings from the business to cover a buyer’s normal living expenses, principal and interest payment on the loan and future capital expenditures, plus a comfortable (for the lender) margin of safety. The strength and accuracy of the business tax returns will be the primary basis for the lending decision. The buyer will need to have sufficient down payment, strong credit and relevant management experience.

SDE:  Acronym for Seller’s Discretionary Earnings.

Scalability:  A scalable company can maintain or improve profit margins while sales volume increases.  A firm (or plant) is said to achieve “scale” when it reaches the smallest output that it can produce such that its long run average costs are minimized. A business model that scales well will be able to increase efficiency and gross margin performance and/or operating profit as sales volume increases.

Seller Discretionary Earnings (SDE):  EBITDA + a replacement general manager’s compensation. This is the most common level of earnings presented for owner-operated Main Street businesses, by business intermediaries, appraisers and sellers.  Comparable sale data often includes SDE and Price/SDE multiples.

Seller Financing:  The seller extends his or her own notes to the buyer in lieu of all cash at closing or other debt financing, such as bank loans.

Senior Debt:  The most secure bank debt and the first in line with primary collateral.  Often senior debt is a short-term revolving loan that is paid down completely within a year.

Stepped-up Basis:  In most asset transactions, the basis of the assets of the target corporation is stepped up in value to the purchaser’s cost. For the buyer this shelters future income from taxes.

Statement of Cash Flows:   A financial statement showing a firm’s cash receipts and cash payments over a specified period.

Stock Sale:  A form of acquisition whereby all or a portion of the stock in a corporation is sold to the purchaser. There are advantages and disadvantages to the parties in a stock sale compared to an asset sale, which vary with the nature of the business and the specific circumstances of the parties.

Strategic Buyer:  A strategic (or synergistic) buyer is one that is willing to pay a premium over the fair market value of a business based on the added economic benefits attributable to synergies between the target business and the acquiring business.

Subordinated Debt:  Refers to non-bank debt, which is less secure than bank (senior) debt.  To attract lenders, borrowers often give subordinated lenders rights to convert their debt to equity.

Synergy:  Interaction among two or more acquired parts of a corporation that creates a combined economic contribution greater than the sum of the individual parts.

Term Sheet:  A preliminary, non-binding agreement setting forth very basic terms under which an investment will be made. The term sheet usually precedes the Letter of Intent.

Tight Money:  When banks hold back on making loans, it restricts acquisitions.

UCC Filing: A security interest in most types of business personal property (promissory note, corporate stock certificate, equipment lease, etc.) is “perfected” by filing a UCC-1 financing statement with the Secretary of State office.

Valuation: The act or process of determining the value of a business, business ownership interest, security or intangible asset. A valuation report is often referred to as a valuation or appraisal.

Working Capital:  The excess value of all current assets over all current liabilities on the balance sheet; represents the liquid funds available to operate and grow a business in the short-term.

Obviously, this list is not comprehensive and contains only a small part of the M&A lexicon. Selling your business may be the most important financial transaction of your life, so learn as much as you can — you’ll only get one chance to get it right. If you would like to learn more about the process of selling your company, I invite you to attend one of our M&A workshops or call to request a confidential consultation.

Small Business Acquisition Financing: What Lenders Want

In ten years of selling private businesses, financial leverage has consistently been one of the key success factors in expanding the pool of buyers and closing deals. Fortunately for business owners, the SBA loan guaranty program is an excellent funding source for deals up to $5MM. And, lenders are lending now. A lender analyzes both the buyer (borrower) and the business being purchased.  Here are 10 things lenders look for when evaluating a loan request for a small business sale/acquisition:

1. Down Payment.  Lenders want a buyer to inject 15%-25% of the total project in cash, depending on several factors including whether real estate is included in the sale. Common down payment sources are retained earnings, savings, retirement plan funds and gifts from family members. Your cash injection cannot be borrowed.

2. Creditworthiness.  Lenders investigate a buyer’s credit at the outset of the approval process. A bankruptcy, foreclosure or judgment usually nullifies their chances, no matter how good other criteria look. Remove blemishes from your credit history before you apply.

3. Track Record.  Individual buyers must have experience in the type of business and/or industry they are buying into. Lenders look for management experience, and they prefer to see prior business ownership. Tailor your resume to highlight your management and applicable industry experience.

4. Cash Flow is King.  Business cash flows must service the loan and provide adequate income for the owners. Lenders analyze the historical tax returns of the business—allowing reasonable adjustments for owner perquisites and non-recurring costs. The quality of financial records comes into play here. Your business plan also comes into play. Synergistic benefits, increases in working capital and capital expenditure needs are considered in the cash flow calculation.

5. Collateral.  Buyers with real property to pledge as collateral may compensate for weaknesses in debt service coverage, business assets, experience, credit, or liquidity. Generally, if you have equity in real property, the SBA requires that it be used to secure your business acquisition loan.

6. Positive Trend.  Nothing scares lenders more than negative sales and earnings trends in a business or its industry. Conversely, a pronounced positive trend is a thing of beauty to a lender. They often look back several years to see how the business performed through past economic cycles.

7. Business Plan.  Buyers have to submit a basic business plan for the business they are acquiring. Lenders want to see an intimate understanding of the business and industry. In most cases a plan calling for modest growth and incremental change is your safest bet.

8. Continuity.  Commitments by existing managers, key personnel, suppliers and customers to continue with the new owner represents reduced risk to a lender.

9. Seller Training.  Lenders want to see a well thought-out management transition plan. The training/transition period can be anywhere from 1-12 months, depending on circumstances. Be sure you negotiate this point up front and clearly spell it out in the purchase agreement.

10. Seller Financing.  When a seller finances even 10-15% of a deal, subordinated to the bank note, it shows the lender that the seller is confident in the business under the buyer’s leadership. This deal point is commonly imposed by lenders.

Finally, for loans over $350,000, or whenever a buyer and seller have a close (non-arm’s length) relationship, SBA lenders require a fair market value appraisal from an accredited business appraiser to validate the borrower’s purchase price. The deal can’t exceed the appraised value. Sellers are advised to prepare months or years in advance, to increase their odds of cashing out when they are ready to exit. Ask yourself, does my business qualify?

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Al Statz, CBA, CBI, is President of Exit Strategies Group, Inc., a business brokerage, merger, acquisition and valuation firm serving owners of closely-held businesses in Northern California. He can be reached at 707-778-2040 or

The North Bay Business Journal, a publication of the New York Times, is a weekly business newspaper which covers the North Bay area of San Francisco – from the Golden Gate bridge north, including Marin and the wine country of Sonoma and Napa counties.

Valuations for SBA Business Acquisition Loans

Determining the value of a business is a key aspect of an SBA lender’s underwriting process for loan applications involving a business acquisition (change of ownership).

According to SBA Standard Oprating Procedure 50-10-5(c), paragragh (i), page 179, for all business acquisition loans over $350,000, or whenever a buyer and seller have a close relationship, the lender must obtain an independent business valuation from a qualified source.  Examples of “close relationships” include transactions between: Employer-Employee; Family members; Co-Owners; and any parties that have an existing, non-arms-length relationship. A “qualified source” is an individual who regularly receives compensation for business valuations and is accredited by a recognized organization.

As Certified Business Appraiser’s (CBA’s) accredited through the Institute of Business Appraisers, Exit Strategies Group, Inc., is a qualified source for business appraisals for SBA loans.

Exit Strategies provides quality, SBA- and USPAP-compliant valuation reports within 2 weeks, at a competitive cost.

Lenders may call Bob Altieri, CBA, at 530-478-9790 to request a quote or receive a sample SBA loan valuation report.

Should we use a business escrow? What does an escrow holder do?

A client recently asked me these questions, and I thought the answers would make a good blog post …

A business sale/purchase escrow holder protects the interests of buyers and sellers of small to medium sized businesses by acting as a neutral independent fiduciary, communications link and closing facilitator. Escrows are used extensively by business transaction attorneys and intermediaries throughout California since regulatory compliance, routine closing documents and administrative details are handled in an efficient, cost-effective manner.  Business escrows are used in both asset and stock sale/purchase transactions. These are the typical duties of an escrow holder in an asset transaction:

  1. Preparing escrow instructions reflecting the terms of the purchase agreement and describing the duties of the escrow holder
  2. Obtaining and holding purchase funds from the buyer
  3. Complying with Bulk Sale statutes (public notice to creditors), when applicable
  4. Obtaining UCC lien searches for state and county
  5. Notifying the county tax collector
  6. Requesting a beneficiary’s statement if debt or financial obligations are to be taken over by the Buyer
  7. Requesting pay off demands from existing lien holders, receiving claims
  8. Notifying and obtaining clearances from county, state and federal agencies as required
  9. Routine consultation regarding questions and problems that arise
  10. Complying with lender requirements, securing loan documents, signing and receiving funds
  11. Prorating expenses and income (taxes, interest, rents, security deposits, etc.), as instructed
  12. Preparing/filing fictitious business name statements
  13. Preparing routine transaction documents and amendments
  14. Preparing estimated closing statements prior to close of escrow
  15. Securing releases of all contingencies and conditions imposed on the particular escrow
  16. Obtaining appropriate signatures on all documents
  17. Preparing final closing statements for the parties, accounting for the disposition of all funds deposited in escrow
  18. Closing escrow when all instructions of the buyer and seller have been carried out
  19. Disbursing funds as authorized by instructions
  20. Recording UCC-1, UCC-3 and deeds of trust, as needed
  21. Securing tax clearances
  22. Distributing final transaction documents to all parties

This list is generic. Escrow duties in an actual business asset transaction in California depend on circumstances and are spelled out in instructions prepared by the escrow holder. The duties performed in stock transfers are quite different.

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Al Statz is President of Exit Strategies Group, Inc., a business brokerage, mergers, acquisitions and valuation firm serving closely-held businesses in Northern California. He can be reached at 707-778-2040.