If you have been in commercial lending or finance for any period of time, you probably have fielded a question regarding how to buy an existing business. Now if you have not had this question, some day you will. This is a common request as there are many reasons for business owners to sell and for future business owners to buy a firm. Typically, the second question after they ask if you can help finance a business purchase is how much they should pay for the business.
There are several methods in determining the value of a business. The easiest way occurs if you have a business that derives all of its income from a single tangible asset. Examples here are an apartment building, office park, or a hotel. In each of these cases, one tangible asset provides the revenue stream for the business. In these cases, revenue comes from apartment rents, office tenant leases, or hotel guests. Value can be determined by utilizing some method like a market cap rate or discounted cash flow analysis.
But what do you do if there is a mixture of tangible capital assets and also non-tangible assets? One method would be to assign values to both the tangible and intangible assets in figuring value. If a manufacturer has real estate and heavy equipment, part of the purchase price can be comprised of the market value of these assets. The remaining value can take into account intangible assets such as the business name, client list, or goodwill.
A second method looks at the tangible net worth of the business and figures a value based upon the owner’s equity in the business. This method may be applicable if the buyer is assuming the existing debts of the company in a stock or ownership purchase. Most business buyouts I have seen, tend to be a bulk asset purchase of all the assets of the company and assuming none of the existing debts of the selling owner.
Typically, with the tangible net worth method, the seller still will want some amount of goodwill for the intrinsic value of the business that is provided to the buyer over and above the market value of the tangible assets.
Another method, the capitalized earnings approach, looks at the value of an investment that is expected by an investor. This strategy seems to be geared more toward buyer than the seller. An example here would be if a buyer of an ice cream shop would expect a rate of return, or cap rate, of 12% on his investment. The overall net operating income, or stabilized version thereof, would be divided by the rate of return to create a price for the business. A variation of this method is the excess earnings method, where a return on assets is separated from other earnings.
A gross income multiple may be used to figure value by using some multiple or fraction of the top line revenue the company produces in a given year. I have seen this done with some medical practices, where this factor is used in determining a portion or all of the price.
Financing a business with large amounts of intangibles can be challenging. Any financing of goodwill would not be able to be collateralized. Some options would be to have the buyer provide additional tangible collateral, allow the seller to carry back junior debt that would carry the intangible value, or utilize some guarantee program like the SBA to help lessen the risk of the collateral shortfall.
A seller carry may be used without or with a guarantee program. The carry must be in a junior position to your loan and may have to satisfy some requirements of the lender or government guarantee. Typically, the business would need to be able to cash flow all the debts. Repayment of the seller carry in some cases may be required to be on some form of standby to the lender debt and may also be required to amortize at a slower pace than the senior lender debt.
We can help you when the business buyout question comes across your desk. We also work with different government guaranteed programs to help better manage the risk in the business purchase. These loan requests can open up new doors of wonderful business for your credit union.