Buying a Company, Part 3
This is the third (and hopefully last) installment of a series of posts on how I went about buying my current business. You should also refer to part 1 and part 2. This installment will focus on options for financing the purchase of a small company and what kinds of legal documents you will need to complete the transaction.
Financing the Purchase
First, you have to figure out how much money you will need. The obvious answer is the purchase price, but this is usually too low. In the vast majority of small company sales, the sellers will strip out all of the cash and working capital. In addition to the purchase price, then, you will need to be prepared to inject additional cash as working capital. Go back over historical financial statements to get a sense of the requirements - and don't forget seasonality. In most businesses, there is a time of year when sales drop but costs stay up and the business demands more working capital. And, if you are growing the business, you will probably need even more (unless you have figured out how to have negative working capital like Dell).
No matter what any book has told you, you are going to have to put in some of your own cash. And that cash needs to be real equity, meaning cash you own and not cash you have borrowed. I don't know how low you can go with equity, and it probably varies a lot anyway. You probably need to plan to put in at least 20% as equity.
The rest you will have to borrow. The first, best source of borrowed funds is the seller. It is very, very usual that sellers will "carryback" a part of the purchase price. If you remember from part 2, we said that it is important to make sure that some of the purchase price is deferred, so that you have some leverage to recover funds against the sellers various guarantees and indemnifications. Thus, this seller carryback or loan serves two purposes. Sellers should always be willing to carryback at least 20% of the deal, and I have seen cases where they will carryback 50% or more. It all depends on the deal and how eager they are to sell to you.
The next source may be family and friends. This is where I ended up closing the financing gap for my company. This might be in the form of gifts or loans. If the funds are a gift, make sure you get a letter stating that from the giver - many banks will ask for this if they ever are considering a loan for you. If it is a loan, you will probably want to try to get them to agree to subordinate their loans to any current or future bank debt. Banks will be willing to lend to you even when you have family or personal debts IF those other lenders are willing to sign an agreement subordinating their debt to the banks (basically, this means that if you go belly-up, the bank gets paid first).
Then, there are the banks. From my experience, it is very, very difficult to get a bank to make an uncollateralized loan - i.e. a loan that is secured only by the cash flow of a company rather than by assets. In fact, I have never been successful at that. About the only way that I have found that banks will make a loan is if it is an SBA loan, where the SBA basically guarantees the loan for the bank. The SBA goes through cycles of being very open to lending to being very tight. I have not dealt with them for over two years, so I don't know what their stance is today. Remember, though, that the SBA is not going to approve any loan where the buyer has no experience in the industry or where the buyer is not putting down his own money as well. The SBA has a lot of information here.
The other way that banks will lend to you is if you have some asset you can commit as collateral. Your home equity is an obvious source. A less obvious source is the very assets in the company you are about to purchase. If you are buying a company with a lot of equipment, particularly with a few large expenses pieces of equipment (e.g. street cleaning trucks in a street cleaning company) it may be possible to get a bank to lend against these assets. Or, if these already have loans on them, it may be possible to assume the loans. Remember that assuming a $50,000 loan from a seller is just the same as paying him $50,000.
Finally, try not to max yourself out. Ideally, you would like to have a bank line of credit with some extra room in it to handle emergencies or opportunities. I began with a line of credit equal to 4% of sales that I have grown to 10% of sales. This credit line has become a competitive advantage for us - it lets us quickly take on new opportunities that our competitors cannot finance.
Once you put together a financing package you think will work, you need to test it to make sure you can make all the payments. You need to put together a spreadsheet by month for at least three years of what you think the P&L and cash flow of the company will be, and make sure that you can make your loan payments. Then try things - what happens if sales drop 30%? If wages go up a dollar an hour? Get comfortable that you can live with this transaction. You are buying a company to make your life better, not drive yourself to an early heart attack.
The Purchase Agreement
This is the key legal document you will prepare. It should include:
1. What you are buying, for what price. In an asset purchase, it includes exactly what assets are purchased - don't forget soft assets like trademarks, contracts, customer lists and other intellectual property. In asset purchases, it also includes an allocation of purchase price to the various asset classes. In an equity deal, you will need to agree on exactly what the balance sheet will look like. Since levels of working capital tend to fluctuate daily, there usually is a price reset mechanism to adjust the price based on the net working capital on a certain day.
2. Guarantees, certifications and indemnities by the seller. For example, they should indemnify you against all past legal actions, against any past taxes due, etc. They should also certify that the historic financial statements you used to buy the company are true and accurate, that there are no undisclosed legal problems or lawsuits, etc. In out case, we attached almost all the key due diligence documents (tax returns, bank statements, P&L's, insurance loss runs, etc.) to the purchase agreement with a certification by the sellers that it is all true and accurate. These certifications and warranties are important - get your lawyer and broker to help. Note that what the seller will not do (unless he is a real sucker) is certify or guarantee that the financial results you get will be as good as his were.
3. A good purchase agreement will specify a mechanism that allows the buyer to net out penalties for these certifications and warranties being incorrect directly from the carryback without going to court.
The next most important agreement is the non-compete. Get one. Every time. No matter what the seller says about not ever wanting to be in that business again (and he may be sincere at the time), at some point in the future he will probably want to get back in. The entrepreneurial recidivism rate is higher than for ex-convicts returning to crime. The non-compete should be for at least 3 and preferably for 5 years, and clearly define what businesses the seller cannot get into. It should also specify defined penalties for breaking the agreement.
Assuming you have a carryback, you will probably have a loan agreement specifying terms and interest rates. In many cases, you may want to retain the seller as a consultant or to help with certain tasks. They should generally provide 90 days of help for free - after that, it is up to the two of you to decide what kind of agreement to hammer out. In my case, the previous owner still works for me part time nearly 2 years later.
A final note on documents
You need to understand and "own" every word in these documents. DO NOT just rely on your attorney to draft and negotiate them. Your attorney does not have to live with the deal, you do. By the third time I did this (remember that I had two sellers back out at the last minute) I was writing everything myself and getting my lawyer to check it. There is no magic about legal work. Yes, they know things you don't, and have standard clauses that need to be added that you don't know about, but that's their job and they will fix those things. Believe me, if you are going to run a small business, you can't run to a lawyer for $400 an hour to draft every little document -- you are going to start learning a lot about being a lawyer whether you like it or not. You might as well start learning now how to write these documents yourself.
I hope this is helpful. Please don't be intimidated -- yes there is a lot to learn, but I started out knowing just about none of this stuff and I managed to figure it out. Running my own company has been fantastic. The actual acquisition and startup part was hugely stressful and time consuming, but I am happy I did it. Good luck.
By the way, I am not a lawyer, accountant, investment adviser, and broker. More importantly, even if I was, I am not your lawyer or adviser. Please don't take this post as advice - treat it as background so you can be better prepared to work with your own advisers.
Posted on October 1, 2004 at 09:32 AM | Permalink
Thanks for taking the time. It's so easy to get so caught up in the detail of running a business that you don't have time to pass on knowledge. Well done.
LBS MBA 93
Posted by: Steve Mercer | Mar 27, 2005 1:28:56 PM
I enjoyed reading your article.
Posted by: harinder | Aug 8, 2005 10:39:36 AM
I've managed to save up roughly $45558 in my bank account, but I'm not sure if I should buy a house or not. Do you think the market is stable or do you think that home prices will decrease by a lot?
Posted by: Courtney Gidts | Nov 16, 2005 6:26:10 PM
Very helpful information provided in plain English. Thanks for taking the time to write this.
Posted by: Kent Hargesheimer | Apr 10, 2006 7:27:56 AM
Thanks so much for the series! I am in the process of purchasing a small retail business and your article(s) gave me some great ideas - easier to read than the many business-written article I have pured over. Now, if I can just get the seller to agree to my offer, I'll be happy!
Posted by: Jackie | Jul 11, 2006 4:54:20 AM
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