Question:
I am not sure whether to buy assets or shares. What's the difference?
Answer:
You want to buy assets, NOT shares. Sellers will want a stock purchase because it will eliminate their future liability. As a buyer you will want an asset purchase to accomplish just the opposite. The first thing you should know is that nearly every small business purchase is an asset purchase, and so it is the norm. Here is a recap of the reasons why you will want an asset purchase:
In very rare situations, a stock purchase may be your only option. This can happen when the business has certain licenses or permits in place that are crucial to the business but may not be transferable, and it would be prohibitive for you to try to obtain the same licenses. In this case, you can complete a stock purchase, but there are two things you need to do:
Asset sales are the norm. It's to your advantage. Unless you have absolutely no choice but to make it a stock purchase simply to operate the business, don't do it!
Question:
I'm considering the purchase of a distributor business I've seen and like. My only worry is that one of their customers generates about 40% of the business. How can I protect myself?
Answer:
The seller has to guarantee that this client will remain on board for a least a year. That's why seller financing is key: if the customer disappears then you can have a clause to lower the balance of sale. As an example, let's say you pay 2 times Cash Flow. And this client represents $50,000/year in CF. If they stop buying within a year then you reduce the Balance Of Sale by 2 times the $50,000, or $100,000.
Your other option is to include an earn out clause whereby you agree on a total price of the business, but "x" amount is not paid at closing and only is awarded to the seller after certain contingencies are met during an agreed-upon time frame. For example, after the first year, if the clients is an active customer, the earn-out amount is considered to be earned. Also, try to negotiate this earn out amount to be paid as part of the existing or new seller note.
Question:
We are currently pursuing a strategic partnership with a vendor of ours. We would like to have a better degree of control on resource allocation in his business. I am curious as to how you would investigate making a move like this. What things should be considered? Equity partner vs. non-equity partner? We are looking to expand our product base to our customers by using this vendor to build the products, and don't want to have problems down the road. Any insight you could give would be helpful.
Answer:
This can be a double-edged sword. The relationship you have with this vendor can be adversely affected should this business deal not work out. At the very least you'll want protection to be certain that you can continue to have them as a source of supply in the event that the business deal goes sour.
Personally, I always prefer partnerships where everyone has a meaningful equity stake and a say in the business commensurate with what they bring to the business. By the same token, you don't want to be in a position where your hands are tied at every step because there are too many generals and not enough soldiers. The business needs a clear definition of who makes the key daily decisions.
Don't turn this into a committee-run business. Partnerships are great when everyone contributes, but they can become an awful mess when all parties have an equal stake and say on all matters. You can tie up the entire decision-making process. Therefore, if you will be running the business day-to-day, then you have the final say on all matters (except for: borrowing money, selling the business, taking in new partners, hiring high priced individuals, etc.).
The key for you is to determine what it is that you want this partner to deliver now and down the road. Who will run the business? You mention that you would like to have a "better degree of control on resource allocation in his business." I'm not certain what this means; however, if this component is your priority then make certain that every mechanism is in place to be certain you achieve your goal. It's worth it to give in on other issues to realize what you want.
Question:
I am interested in opening a retail shoe store, but I don't have enough capital. My friend is willing to loan me the capital for a stake in the business. I will do all the work and my friend will be a silent partner. What would be a fair arrangement for us as partners?
Answer:
This is an excellent question and an interesting situation from both a financial and personal perspective. Financially, if you will be running the business, then you should be entitled to receive a reasonable salary for the work that you perform and possibly a bonus based upon achieving certain levels of profitability. If your partner/friend is not working in the business then he/she should not be entitled to a salary but rather a reasonable return on their investment plus a financial stake in the business.
Obviously, it behooves you to negotiate the greatest percentage of equity for yourself in this deal, but you must be fair. Of equal importance is to have an arrangement whereby you will be able to make all of the daily business decisions without their involvement. To do so means you will need to be the majority shareholder, and only major decisions such as hiring people at certain salary levels, incurring any debt, binding the company, or selling any portion of the business must be subject to unanimous consent. You'll want to seek the input of a competent attorney to formulate an equitable shareholder agreement.
On a personal level, your relationship will be forever changed with this person. You both have to be mature enough to try to keep business issues separate. No opportunity is worth jeopardizing a friendship, in my opinion. Plus, you must realize that they are the vehicle by which you will be able to become a business owner and that brings a substantial amount of implied debt on a personal level.
Question:
Why do people not include A/R when selling a business? When we buy businesses sellers don't seem to understand that we want the A/R because we based the price off of 12 months; without the A/R we’re only getting 11 months. Do you see this as a common problem?
Answer:
This is a great question! I don’t necessarily see this as a common problem as much as it is a common occurrence. The philosophy behind not including A/R is that the seller delivers the business “free and clear”, taking the A/R and paying off the liabilities. In smaller businesses the seller almost always retains the A/R. The impact of this is:
On smaller businesses, because this is the norm (right or wrong), you will be hard pressed to convince any seller or intermediary otherwise. The flip-side of the points noted above is that if A/R was included:
Since almost all small business sales are transacted as asset and not stock sales, buyers typically do not want to assume any liabilities. In larger transactions, buyers generally require the sellers to leave the business with an acceptable net working capital position. However, this is definitely not the norm in smaller transactions.
Having said all this, in my experience, when a buyer is paying a fair price for the business and really pushes this A/R and net working capital issue, they almost always get some concessions from the seller. The main point is that you are buying an “ongoing” entity and so it has to be turned over and be in a position to sustain current activity, and adequate working capital is an integral part of fulfilling that requirement.
Question:
I am looking at a do-it-yourself pool supply business that's been around since 1977. They have a great reputation and are always busy. There are no nearby competitors. The sale price includes the building. I'm not really sure if I can (a) afford the real estate, (b) if I need it, and (c) how this impacts the valuation of the business and (d) is there anything else I should consider? The seller definitely wants to sell the real estate. Can you let me know your thoughts?
Answer:
This is an excellent question and you have obviously thought out the key concerns one should have in this situation. Let me address each one individually and provide you with the pros and cons of each scenario:
Can you afford it?
Generally speaking, it is easier for you to obtain financing on the real estate portion of the business than on the business itself. If you are going to use a third-party lender (outside of the seller), it is quite possible that they will want you to acquire the real estate as well. The cash down that you will need may vary between 10-20%. Some lenders require a higher percentage down when the building is owner occupied, meaning that the mortgage payments are in fact predicated upon the performance of the business. Others don't care as much.
On the other hand, your primary goal has to be to sustain and build the business and so you need to determine if your capital will be better allocated to marketing and other strategies versus being tied up in real estate.
Also, have you discussed the possibility of the seller holding the mortgage? Doing so may even allow you greater leverage on then financing the business portion as well, since they will have additional security and many sellers who provide financing for the business will feel more comfortable knowing that you're in their building where they can keep an eye on you.
Do you need it?
This is probably the best question to ask. The best answer lies in whether or not the business relies on the location to drive the business. Given that they have been around for nearly 30 years, it's obvious that customers know their location well. If you do not buy the property then it behooves you to have a long-term lease with the owner. If that is not possible and you are forced to find a new location most customers will follow you, but it is very possible that a competitor will try to open in the former premises. As such, the rule here is this: if the business depends upon the location to drive the sales, then you must either buy it, or have a long-term lease in place. If this is not the case, then you can consider whether it makes sense from a financial and investment perspective.
Pay Attention:
If the seller owns the property, he probably has it outside the business. The business may only be paying the bare costs to cover the mortgage, insurance and taxes, or, he may be paying a premium. Whatever it is, if you do not purchase the real estate and enter into a lease, you may have to adjust the Owner’s Benefits to account for the difference between what the business was paying the owner before in rent and what your new costs will be.
How it impacts the valuation of the business?
It shouldn't. The real estate should be valued as a stand-alone entity using industry comps, current market factors, and other such criteria common with real estate valuations. Further, a certified appraiser should be engaged to determine the value.
One thing to consider is there can be a premium for the property if the business depends upon it to drive the revenue. Likewise, the value can be decreased if only this kind of business can be located there which one would see in cases such as nurseries, car dealers, etc.
Other Considerations:
Personally, I usually like to avoid buying the real estate associated with the business initially because the costs are generally more than renting (although you should always negotiate an option and right of first refusal on the property) and I always want to allocate as much money as possible to building the business and for working capital, of course. However, I would always be sure to keep my options open and suggest you do the same should you decide not to buy the real estate right now. To accomplish this you can:
As a final note, consider having the seller hold the mortgage on the building. You can likely negotiate a minimal down payment with them compared to a bank. You may want to consider a premium interest rate. Look at the various payment options available as you are usually better off to pay a higher rate and get a longer amortization to less severely impact the business' cash flow.
By: Richard Parker: President of The Business Buyer Resource Center and author of How To Buy A Good Business At A Great Price©