Pricing and Funding a Business
Many articles in this space have discussed the importance of properly funding or capitalizing a business operation. The lack of adequate working capital is the number one reason that many new businesses fail in the first few years. Even established and profitable businesses run into cash flow problems. There are two important issues a business buyer needs to be clear about before setting about the actual process of purchase—what is the true value of the business he/she intends to buy, and what is the best way to fund the purchase.
Pricing a BusinessThe first step is to determine how much money is needed to purchase or start up a business and to keep it running. There are many variables that go into the price of a business and you should definitely conduct your own research or use a business broker before making any long-term decisions. However, here is some information that may be helpful.
A recent report published in BizBuySell.com found that the average price for an existing business in the first quarter of 2011 was $244,500 for a business that generated a median cash flow of $103,867. There are also some rules of thumb that have evolved for different industries. The information below was extracted from a helpful resource guide on valuing existing businesses written by Richard Parker at The Business Buyer Resource Center:
- Existing Self-Serve Food Franchises: one to two times Owner’s benefits
- Existing Full-Service Restaurants: one to three times Owner’s benefits
- Existing Hotels: three times Owner’s benefits (Owner’s benefits include salary, perks, income and tax benefits taken by the principals out of a business on an annual basis.)
For new franchised businesses, a franchisor is required to provide you with a full listing of all costs associated with starting the business. In the convenience store industry, it is a common practice to pay a landlord who has built and fully equipped store by signing a long-term lease and purchasing the existing inventory. As you can see there are as many ways to price a business as there are businesses.
Funding the BusinessIn addition to the purchase price, you should plan on having sufficient cash to fund a business for at least the first six to twelve months of operations. It goes without saying that you will need a budget and good financial controls in place to make sure you are covered.
Once you have identified and properly priced a business, you will need a funding source. There are many sources of cash but the one that is right for you will depend on your industry, number of years in operation and the type of assets that are owned.
A. Self Funding: Buying a business from your own savings is of course an option and does not require anything other than figuring out which account or stock portfolio to cash out. However, using your own resources does not always make the most financial sense. For example, if all your assets are tied up in an IRA or other retirement plans, the taxes and penalties that you will incur when you withdraw funds should be taken into consideration. Also, if you anticipate needing your savings for other uses such as a child’s college tuition, you many not want to tap into those liquid accounts.
B. Traditional Loans from Banks and Financial Institutions: This type of funding is most commonly used for retail businesses that have assets, an operating history, and an owner with good credit. Hotels, convenience stores and restaurants are often funded by bank loans. Be prepared with an up-to-date personal financial statement and historical information on the business. You should also be ready to pay for the cost of an appraisal, background checks, and the other expenses of the bank such as legal fees.
C. Seller Financing: This form of funding has become much more common due to the tight credit markets these past few years. Sellers ranging from landlords to franchisors are offering loans in order to sell their businesses quickly. Depending on the sophistication of the owner, the loan process may be just like a bank’s or much more informal. The advantage is that the lender has a lot of incentive to make the loan and understands the assets that are being used as collateral.
D. Friends and Family Loans: This type of funding has been very popular and successful among the Asian community. It is being utilized even more in this difficult lending environment. Entrepreneurs favor friend and family loans because there is relatively little expense in obtaining the loan when compared to loans from institutional lenders. Additionally, these loans are often made without any current interest charges. This of course will help new businesses increase their cash flow. Though this is an attractive solution you should be cautious when obtaining loans from family and friends as you will not have an experienced lender doing its independent due diligence on the business and raising any red flags based on their experience. Further, the personal relationship between borrowers and lenders can lead to deals done without proper documentation, causing misunderstandings and disputes that strain relationships and cause an otherwise successful business to fail.
E. Investors’ Funds: Entrepreneurs will often choose to raise capital for their business from investors as equity rather than as debt in exchange for an ownership stake in the business. This type of funding is attractive because the capital usually has no interest charges. However it is important to understand the pitfalls of this type of funding. You will have to manage non-operational partners who may have different expectations as to return on their capital and how the business should be operated, resulting in some loss of control. You will need proper agreements with the investors so that a decision-making process in place. It is important to note that depending on the amount of funds and the type of investors you are seeking complex security laws may apply that can have both civil and criminal implications if not complied with.
Finally, don’t forget to get advice from a CPA, loan officer, and an attorney with experience in the industry that you are buying into. They will have seen many businesses come and go and will be able to thoroughly vet a financial statement or advise you on what to do to avoid common problems.
Disclaimer: This article is for general information purposes only, and does not constitute legal, tax or other professional advice.
[Business Insights is hosted by the Law Firm of Kumar, Prabhu, Patel & Banerjee, LLC (KPPB). Sonjui L. Kumar is a founding member and partner of the firm. Her areas of practice include general corporate law, complex commercial transactions, and trust and estate planning. Samir Patel is also at KPPB, with areas of practice being commercial real estate, real estate finance, general corporate and partnership law, SBA and CMBS (conduit) financing.]
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