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.

Valuation

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