A lending opportunity that’s not for the faint of heart

Change of ownership: A lending opportunity that’s not for the faint of heart

Garry Barnes

There are a number of financing issues associated with the acquisition of an existing business, especially when it comes to establishing the value of the business.

We are the stewards of our customers’ deposits and our stockholders’ investment. We are expected to maintain a level of liquidity and investments to allow the return of our depositors’ funds, including interest, while generating an acceptable level of profitability to satisfy our shareholders, all within an acceptable framework of risk. No small task, regardless of the bank size!

As we grow and diversify our loan portfolio, we continuously examine new lending opportunities to enhance continued profitability. Perhaps the sector that most readily comes to mind as holding the most opportunity is small business, defined by the U.S. Small Business Administration as follows:

* 500 employees for most manufacturing and mining industries.

* 100 employees for all wholesale trade industries.

* $5 million for most retail and service industries.

* $27.5 million for most general and heavy construction industries.

* 11.5 million for all special trade contractors.

* $0.75 million for most agricultural industries.

Including the self-employed, small businesses account for 58% of the private, nonfarm work force, contribute 43% of all sales in the country, generate 51% of the private gross domestic product, and contributed a major share of the millions of new jobs created during the late 1990s.

An expertise in providing financing for the change of ownership of closely held businesses would appear to serve a bank well.

Historical Review

One of the first steps in the purchase of a going concern–for the potential buyer and, later, the bank–is to perform due diligence. How long has the company been in business? What is the owner’s background? What is the reputation of the company in the community?

A thorough review of the company’s financial statements is necessary to demonstrate the firm’s ability to meet future obligations, including, of course, debt service. Financial statements also help the seller/buyer determine selling price and the banker to confirm the logic of the selling price.

Goodwill. The loan officer can anticipate that “blue sky,” goodwill, or intangibles will always be part of the selling price but has no collateral value! Goodwill is an accounting entry that adjusts for the premium price paid in an acquisition. When a buyer pays more than fair value for the assets, the difference is recorded as an asset.

Historically, goodwill was written off or amortized against earnings over a period of time, thus reducing profits. The Financial Accounting Standards Board, or FASB, changed the rules last year, and companies can no longer extend the write-off over time. Now companies are required to annually assess the value of goodwill. If considered “impaired” (of questionable value), the firm must take a onetime write-off, which may have a dramatic impact on earnings. The loan officer must understand this process. Outside counsel may be needed for all parties involved.

Future earnings. Continued analysis of the company’s financial information may reveal greater insight about the quality of the firm’s historical earnings and potential earnings. The loan officer should understand the meaning of such factors as cash position, overdue account receivables, slow-moving inventory, and debt capacity and their effect on the selling price and the amount of the loan request.

In addition, the banker must evaluate the probability of maintaining and expanding the level of future earnings–the primary source of repayment. A number of considerations should be made of issues that affect the selling price and the amount of the loan. For example:

* What if a manufacturing firm is dependent on a specific type of plastic and suddenly the availability of the plastic is greatly diminished?

* What if it became necessary to transport the plastic from a source several hundred miles away? The increased costs will quickly decrease future profits.

Future earnings of a business may also depend on the purchase of additional machinery or inventory. If such additional investments are required to maintain the present income level, specific adjustments may be made in arriving at the selling price and the loan amount.

Internal and external relationships. Labor is another area of concern. Is the plant taking a union vote in the near future? Are key employees willing to stay on with the new owners?

Customer and vendor relationships deserve considerable attention as well. For example:

* What is the company’s reputation with its customers and potential customers?

* Is the principal customer of the present owner, say, the son-in-law? What reasonable assurance is there that the principal customers will remain with the company?

* Are there customer problems currently? If so, posting a new sign “under new management” on the marquee may not suffice to save the company’s reputation.

* What do the creditors (trade suppliers, current bank, and so forth) think of the company and its future? Will they continue to extend credit?

Tax and liability issues. Although it’s not the purpose of this article to address legal or tax issues, it is appropriate to briefly mention a few basic tax considerations. When purchasing a firm, the buyer may acquire either the assets of the company–that is, the receivables, inventories, equipment, plant, land, and so forth–or the corporation’s stock. Since the method used will probably affect the buyer and seller’s tax liability, it may also have an impact on the purchase price. The tax aspect of purchasing and/or selling a business is a very technical and constantly changing matter. Consequently, it may be advisable that all parties involved, including the bank, secure at the outset competent tax counsel.

If it is decided to purchase the assets of a company, the parties involved may wish to have legal counsel draft a sales contract identifying the specific assets being sold and the amount paid for each item. This agreement will, among other things, provide a basis for depreciation and perhaps the total tax liability. For example, if equipment carries a high value in relation to the total sales price, the periodic depreciation charges will be greater. If the inventory is priced at a high value, gross margin on sales will be reduced and, accordingly, so will the tax liability. Land, on the other hand, cannot be depreciated and therefore may carry a low value. All these issues affect the selling price and the loan amount! These decisions will also influence the net operating income of the new company and should be thoroughly understood by the loan officer.

One aspect of buying the assets of a company is that the buyer may avoid all liabilities of the corporation. For example, if the company is facing potential litigation, perhaps unfilled (generally for millions of dollars), the buyer may not become a party to this legal action. The purchase of a company’s assets may also be a relatively simple process. Essentially, the transaction simply requires the approval of the board of directors and/or stockholders of the selling company.

Should the purchaser decide to acquire the company’s stock, the price will, or course, include the value of the assets, such as uncollected receivables, the inventory on hand, and the unrealized profit from these cyclical assets. Normally, the agreed-upon price entitles the new owner to all of the assets of the company and will include all liabilities, known and unknown!

Noncompete issues. When buying a going business, it may be desirable for the buyer to pay the former owner an additional sum not to open another business in the respective trade area.


Once the analysis is completed and the buyer is reasonably confident about the potential of the business, it’s time to establish the selling price. Unfortunately, many values can be placed on a company, some of which may have no relationship to reality. Frequently, the listing price of the subject company is established by a business broker using a rule of thumb such as four times gross sales–considered a “standard” in the industry, yet, when this price is factually analyzed, the value may not have a basis of support.

In reality, businesses are as different, unique, and complex as the individuals who own and manage them. Therefore, simplistic rules of thumb may not be an acceptable way of valuing a business. So what is value?

For the purposes of this article, value may be defined as the worth of the firm’s assets and the perceived future economic benefits to be received over the life cycle of the company. Generally, the economic benefits will depend on the expected cash returns and the prospective buyer’s required return on dollars invested.

There are a number of quantitative valuation models available. The following methods are accepted by the U.S. Small Business Administration when guaranteeing loans to finance the sale of a business (change of ownership):

* The gross revenue multiplier.

* Adjusted book value.

* Discounted future earnings.

* Capitalized adjusted earnings.

* Cash flow valuation.

According to the SBA, the analysis can be performed by a bank loan officer or an independent person qualified, in the opinion of SBA, to perform business valuations.

The bank’s lending policy should direct that an independent valuation be completed. However, in reality, rules of thumb, as discussed above, are generally used more than other methods.

There is no one right answer or exact value. The ultimate price that the seller and buyer finally agree to is generally a result of a series of negotiations–a certain amount of give and take on both sides–stemming from a logical analytical process that includes one or more of the above concepts.

The Acquisition-Financing Plan

Once negotiations between the seller and buyer are over, due diligence completed, and the selling price established, the next step is for the buyer to develop an acquisition-financing plan. The following is a summary of the documentation the bank should request in order to adequately review the loan request package:

* A written detailed description of the business to be acquired.

* A signed copy of the buy/sell agreement, to include a detailed collateral list, which will be offered as security for the loan, plus an estimate of the current value of each item.

* The buyer’s resume, describing the new owner’s experience and management capabilities.

* Statement as to how much cash the owner intends to invest in the business.

* A detailed business plan, stating the company’s specific objectives and how the goals will be accomplished.

* Balance Sheet and Income Statement on the business entity:

* for the last three years

* original signatures and current date.

* Current Balance Sheet and Income Statement on the business entity:

* within 45 days–capital account should balance from year to year

* original signatures and current date.

* Detailed Term Debt Schedule on the business entity:

* listing creditor, original date, original amount, present balance, interest rate, monthly payment, maturity date and collateral

* original signatures and current date.

* Business Tax Returns on business entity:

* for the last three years

* original signatures and current date.

* Balance Sheet on all Principals

* original signatures and current date.

* Tax Returns on all Principals

* for the last three years

* original signatures and current date.

Collateral value. At some point, the loan officer must evaluate and determine the collateral value of the assets involved in the acquisition and offered as security for the loan. In many cases, the aggregate value of the collateral will be less than the amount of the loan. That in itself does not have to mean a decline. There are several alternatives to be considered.

* Find out if the bank is willing to make a loan with less than 100% collateral.

* Ask for additional collateral, such as a second on the buyer’s home or other assets of value the buyer may own.

* Ask the seller to take a “carry-back” on a portion on the selling price and accept a second lien position behind the bank.

* If cash flow is an issue, the seller may be willing to defer some or all of the payment until such time that the company can support the additional debt.

Repayment term. Repayment term is also an issue that must meet everyone’s needs. Again, depending on the bank’s lending policy and liquidity needs, the term can and should generally be structured to meet the borrower’s cash flow needs as well as the economic life of the collateral. If commercial real estate is the primary collateral, 20 to 25 years may not be unrealistic. Seven to 10 years may be reasonable for equipment and up to five to seven years if working capital is part of the loan proceeds. If all types of collateral are included, as is frequently the case, a blended term may be appropriate. The loan officer may use a weighted average to calculate the overall term.

Pricing the Loan

Pricing is a major issue in structuring and approving any loan. Financing the change of ownership may command a high price to compensate for the added risk. Naturally, the quality and value of the collateral, strength of the borrower, level of cash flow, and repayment term are all factors to be considered in this process.

In other words, the lender should price for risk. No one will argue with this philosophy. However, deals are frequently priced on the loan officer’s fear of losing the deal. Little or no thought is given to cost of funds, margins, or risk. Given this method of pricing, is it any wonder bank margins are decreasing year after year?

Pricing is a huge issue with long-term implications. Current pricing philosophies and levels are not apt to change until management takes two important steps:

* Better inform and train loan officers regarding asset and liability needs.

* Emphasize that new volume without regard to appropriate pricing will only create new problems.

In most cases, loan officers are held accountable for volume growth but not margin growth. If a bank is not happy with its margin trends, only senior management can act to make necessary changes.


Understandably, financing the sale of a going concern may not be for all banks. However, management should remember that change of ownership financing may not be the easiest for the buyer to obtain. Therefore, the loan officer has the opportunity to cross-sell many other services and establish a long-lasting, profitable, and mutually beneficial relationship with a new entrepreneur. The banker should keep in mind that this new entrepreneur is the conductor of the engine that runs our economy!

Barnes is a 25-year commercial banker living in Phoenix, Arizona. He has taught at the university level, at four banking schools, and for the Small Business Administration. He has conducted over 2,500 seminars, hosted a radio talk show, consulted with the Central Bank of Russia (in country), and has written for numerous publications, including RMA’s Journal.

RELATED ARTICLE: Establishing Value

The following are a few drivers or determinants of value that the lender may wish to take into consideration when reviewing the logic of the selling price:

* Owner’s reason for selling.

* Length of time the company has been in business.

* Length of time current owner has owned the business.

* Quality of financial statements.

* Historical profitability.

* Projected future profitability.

* Location.

* Growth history.

* Competition.

* Barriers to entry.

* Potential for the industry and product.

* Customer base.

* Technology.

* Value of existing equipment & real estate.

* Regulatory issues.

* Environmental concerns.

* Degree of risk and mitigants.

Appraisal Methods

Gross revenue multiplier: A measure of total annual sales times a multiplier, i.e., 4 (multiplier) X $ 1,000,00.00 (gross sales) equals suggested selling price.

Adjusted book value: Determined by adjusting the firms assets and liabilities to current market value, resulting in a new (adjusted) book value. This method is seldom used because it gives no value to future potential earnings.

Discounted future earnings: Calculate several years (five years may be used) of future net earnings estimates and then discount each year’s net earnings to present value. The sum of the present values may equal the assumed value of the business.

Capitalized adjusted earnings: Very similar to the “cap rate” concept used in real estate investing. Use prior years net earnings divided by the assumed capitalization rate, resulting in an assumed value of the business.

Cash flow valuation: Determined by calculating the firm’s annual cash flow (usually normalized) multiplied by an assumed multiple, as used in the gross rent multiplier.

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