Something Special

The following letter and response refers back to part 3 of Bill Martin’s article, Asking for Guidance. (Go to Part 1 here.)

Bill,

Read your article on the BBP blog…very interesting and applicable. I’d say a majority of the businesses I visit in this area fit into the category of ‘too much asset’ for cash flow…generally that asset causing the problem is real estate included in the sale. It seems to me this causes the same problem as ‘fancy’ equipment, etc. Am I wrong? You mention “unless the seller is willing to do something very, very special (which I’ll explain some other time)”…I’d appreciate your elaborating on that a bit.

Regards
Montana Broker

BILL’S RESPONSE

Thanks for the kind comments.

The banks I deal with call these business elements “underperforming assets”. That’s any asset that isn’t producing enough profit to make the deal viable.

For example:

If an owner has a business that is generating EBITDA + owner benefits (what I call NOB…Net Owner Benefits) of, say, $200,000, and, if that owner also owns a building that might appraise at $1,000,000, I would do the following evaluation:

(a) price of building at $1,000,000 less buyer’s down payment of $100,000 = loan on real estate of $900,000. Payments on 20 year note on real estate = $77,375 (including principal and 6% interest).

(b) $200,000 NOB minus the mortgage payments of $77,375 = adjusted NOB of $122,625.

(c) That makes the business selling price $122,625 x 3 (at the most) = $367,875 (or less).

(d) Priced at $367,875, less a buyer down payment of, say, $87,875 would equal a business acquisition loan of $280,000. The payments on that loan (7 years, principal and 7% interest) would be $50,711, which, when deducted from the adjusted NOB of $122,625, would leave cash flow of about $71,913.

Although that’s no “ideal deal” for a buyer, it is possible to find a buyer who might pay $87,875 down to buy a $71,913 job. Actually, if the business were priced at 2.5 x adjusted NOB, the chance of selling this business goes up tremendously.

The seller of a business with a NOB of $200,000 is unlikely to like the $367,875 price. But, because the seller has housed the business in a building that is too “rich” for the profits being generated, that’s the reality of the situation. A seller that wants more than $367,875 for this business, with this expensive real estate included, is off in “la la land”, expectation-wise .If the broker prices the business at, say, $600,000 (plus $1,000,000 for the real estate), on a 7 year loan (including principal and 7% interest), the payments would be $81,500, which has to be paid out of the adjusted NOB of $122,625, leaving the poor buyer prospect with only $41,125, pre-tax, to pay himself a salary, and to generate a return on his investment (down payment), and to provide operating reserves for growing the business. In my experience, I never meet a buyer who will pay $150,000 to buy a $41,125 job, let alone go into debt $1,350,000 for the “privilege”. And, buyers who have accumulated $150,000 down payment, are rarely able to support their family on only $41,125.

Brokers who ignore the “burden” of the underperforming real estate in this example, and who dream of somehow talking a buyer into this “bad deal”, are the ones that “spin their wheels”, fill their lives with unsellable, un-financeable listings, and end up frustrated at the least, and broke at the worst.

And/or the broker who over prices this business will get offers that are way below the listed price, which makes the seller angry, forces the broker to join forces with the buyer in arguing with the seller, and creates bad feelings all around.

Plus, brokers who present such preposterous, illogical deals to buyers, are not respected by the buyers. These are the kinds of pricings that have caused zillions of buyers, nationwide, to disrespect the business brokerage profession, and to mistrust the advice/leadership of brokers. This also leads to the incredible amount of mistrust that buyer’s accountants, attorneys and bankers have for business brokers. This over pricing “system”, so commonly practiced by business brokers nationwide, is also why most brokers only sell 20% of their listings annually, a horrible statistic reported by Tom West’s annual survey of our industry.

Let’s say, instead of selling the real estate to the buyer, the seller is willing to lease the real estate to the buyer. Again, if the seller wants “normal” rents for his $1,000,000 building (normally commercial real estate is rented at about an annual rate of 1/7th to 1/10th it’s appraised value), which would be $100,000 to $143,000 per year, that’s a worse situation than if the buyer buys the building, as it sucks up even more of the NOB.

Or, let’s say the real estate is owned by a 3rd party, not the business seller, and the business has a NOB of $200,000 after rent expense and all other operating costs. But, let’s say the underperforming asset is too much slow-moving inventory. Or, equipment that cost the seller so much that he is tempted to over price the business in order to recapture his investment in that equipment. Again, as with underperforming real estate, no matter what the underperforming asset is, if it leads the seller and broker to price the business at a price that forces the buyer to have inadequate cash flow, that listing is unlikely to sell.

And, as my article in The Business Broker Press points out, debt service is debt service, whether it’s owner financing or bank financing. So, seller financing is not the answer to this challenge. No matter who the buyer owes the money to, if he can’t service the debt, and if he can’t have an adequate remaining cash flow, the entire project is an “exercise in futility” most of the time.

However, one technique that solves many of these challenges is as follows:

If the seller’s “underperforming asset” is too much slow moving inventory, we’ve convinced hundreds of sellers, on hundreds of different deals, to leave the slow moving inventory on consignment. So, the buyer buys all the other assets, at a multiple of 2.5 to 3 times the NOB, and the parties have a Consignment Agreement” on the questionable inventory. We’ve used this technique on everything from a retail store to a multi million dollar distributorship. The Agreement obligates the buyer to insure the inventory, be responsible for it, keep it dry and stored safely, and, allows the seller to visit the business periodically (after the take over by the buyer), audit the consigned inventory, and, if any of it is missing, the buyer pays the seller at that time, at the seller’s original cost for that inventory. There is no interest paid to the seller, as it’s consigned inventory, not a promissory note. The buyer’s bank, that’s making the acquisition loan, loves this arrangement, as it minimizes the risk for the buyer and bank, and it provides the buyer with “free” inventory, with no payments due until it’s sold at a profit, with the buyer keeping any profit, when it’s sold. The seller benefits, by (a) getting the business sold, instead of being “stuck” with it, and (b) gets cash at closing for the non-inventory assets, and (c) has a way to turn the “dead” stock into cash, over time, as the buyer sells it off. The buyer can promote that inventory, at a bargain price, to the business’ customers, giving the buyer a great promotional element to exploit. Everyone wins. No one loses. And, the broker gets a deal that makes sense to everyone.

Similarly, if a seller has equipment that’s “too rich” for the cash flow, the seller can lease that equipment to the buyer, and sell all the other assets (including the “blue sky/goodwill/cash flow) to the buyer.

The only asset that is hard to work with is real estate that’s “too valuable” for the deal. In that case, unless the seller’s willing to keep his building, and allow the buyer to move to a more reasonable location, there is little you can do to help a seller with underperforming real estate. And, a buyer that’s encouraged to move the business is going to expect to pay less for the business, to cover the moving costs. However, if the seller has a building that’s larger than the buyer needs, the seller could lease only the space needed to the business buyer, and lease the rest of the building to some other tenant. Or, the seller could charge the business buyer for the space the buyer needs, and allow the buyer to sub lease the rest of the space to other parties. Or, of course, the seller could simply charge the buyer a dramatically lower rent amount (especially possible if the seller has no mortgage, or a low mortgage to pay), so the buyer can survive financially if he stays in that building, at a “do-able” rent.

There are other techniques we’ve developed, besides the ones shown above, that “save” deals, make listings more sell-able and more finance-able, and result in our having been able to sell 60% or more of our active listings, in those offices that follow the advice we give them. And, there are more details to the above techniques that I won’t try to explain in this memo. I’m sure your great organization has developed workable solutions, as well.

I hope these tips help you in your business brokerage journey. And, I hope that others in our industry, who, perhaps, haven’t yet discovered these particular systems, will benefit, as well.

Best Regards,

Bill Martin
Dearborn Property Management, Inc
913-553-0570