Category: Buying a Business
5 SBA Loan Myths & Steps to Getting an SBA loan for Business Buyers-Sellers
Getting an SBA Loan to buy or finance the sale of a business is a great way for buyers to leverage their cash to obtain a lower down payment and buy a bigger, more profitable business. SBA financing also offers benefits to business sellers because it gives them cash at closing rather than having to finance the transaction themselves with a large Seller Note. SBA financing is a win-win for business buyers and sellers.
In addition to the obvious benefits of a low down payment for the buyer and cash at closing for the seller, SBA financing other significant benefits. SBA financing offers 10 year financing at a maximum rate of Prime + 2.75% as compared to Seller Notes that are typically 5 years at 8%. The reduces the buyer’s debt service and increases their net after debt service dramatically. SBA lenders will also often finance the purchase of the seller’s receivables (A/R) which provides additional working capital for the buyer and again cashes the seller out at closing since he doesn’t have to wait to collect the outstanding A/R.
5 SBA Financing Myths, busted
- It takes months to get an SBA loan!
It’s a common myth that it takes several months to get an SBA loan, some think it can take 6 months. At Pacific Business Sales we SBA financing typically takes 45 days to 60 days and we run the SBA financing in parallel with Due Diligence and Escrow resulting in the bank being ready when escrow is ready to close. We work exclusively with a select group of SBA PLP (Preferred Lending Program) banks that have excellent underwriting teams and quick closing processes. We do not work with loan brokers that will “shop” the loan around and do not work with non-PLP lenders.
- SBA Loans are nearly impossible to get!
SBA loans do have a lot of paperwork and yes, both the buyer and business must qualify, but if the deal makes sense, SBA financing is a viable option. At Pacific Business Sales SBA financing is our preferred transaction structure and in fact over 90% of our transactions use SBA financing.
- SBA Loans require a ton of paperwork!
OK, this one is not a myth, SBA loans do require paperwork from both the buyer and seller. But if you are working with an organized lender, and broker knowledgeable about SBA financing, it goes smoothly and is well organized. We start the SBA application process as soon as the offer is signed and run it in parallel with Due Diligence. Our lenders send a checklist and work with our clients to track the status of the loan application. Our lenders also have secure file sharing systems where buyer and seller can easily upload their documents.
You’ll spend weeks trying to get an SBA loan and get rejected at the end!
This does happen with inexperienced brokers and when buyers use a non-PLP lender or a lender that doesn’t pre-qualify the deal. At Pacific Business Sales we pre-qualify all of the businesses we represent. This ensures the business qualifies for SBA financing upfront. When an offer is accepted the first step in our transaction process is to have our SBA lender review the transaction and pre-qualify the deal. This eliminates ugly surprises later in the transaction process.
- You have to have a lot of collateral to get an SBA loan
You don’t necessarily have to have a lot of collateral to get an SBA loan, in fact, some transactions are done with very little collateral. Having strong collateral absolutely helps in getting the financing approved, but it is not necessarily a deal killer if you don’t have a lot of collateral. Underwriting approval depends on many factors including, the overall strength of the deal, buyer’s experience. Buyer’s credit score, business financials, and collateral.
7 Steps to Getting an SBA Loan
- Find the Right SBA Lender
Finding the right lender is a critical first step. The “right” lender may not be the one you found on the internet that is hard-selling you and is certainly not one of the big-box retails banks. If you are shopping SBA loans you hear lots of promises and sadly will have lots of broken promises if you choose the wrong bank. You want a PLP lender that will close the loan and closes quickly.
The buyer will be choosing the SBA lender and it is critical to choose the right lender. There are many SBA lender choices and it is difficult for a buyer to know with certainty which bank is the best choice. Every bank has different industry preferences and underwriting practices. Much of the bank selection is a matter of knowing which bank will “like” this deal.
It is best to work with a bank directly and only use a loan broker in rare and extenuating circumstances. Loan brokers make a lot of promises they can’t deliver on and the banks cannot necessarily follow through with.
- Approvals and more Approvals; Pre-Approval, LOI, and Final Approval
There are lots of “approvals” along the way to funding and closing. First, the buyer will get a “pre-approval” which isn’t a promise or commitment to the deal, it mean exactly what is says, after initial review, the buyer appears to be qualified. Next is an LOI (Letter of Intent) from the lender which again is not a promise to offer financing. This comes after the lender has done an initial review of the buyer and business and it looks good, but still needs to go through full underwriting review. The last approval is the Final Approval letter from the lender which comes after underwriting review is complete and appraisals on the business and collateral are complete. Once Final Approval is received the bank is typically ready to fund in 5 to 7 days.
- Business Pre-Approval
At Pacific Business Sales the first SBA approval for the business is handled shortly after listing. We want to ensure that we have a lender in place that will approve the financial parameters of the transaction as well as the industry. It is important to know which lender is willing to close on the loan with the right buyer and how much of a down payment they want 10%, 15% etc. and what they will lend. If the business was not pre-approved or reviewed in advance by the lender then this will be step one along with buyer pre-approval since the bank is starting from scratch with the business.
If the business has not already been pre-approved the bank will require the following information from the seller:
a) last 3 years tax returns
b) last 3 years P&L and Year to Date P&L
c) Current Balance Sheet
d) A/R and A/P aging report
e) Owner’s W2s last 3 years and year to date Payroll report
f) verification of seller’s expenses and add-backs
- Buyer Pre-Approval
After the offer is accepted the buyer will submit the financials and personal information with an application to the lender (usually within 15 days of signing the purchase agreement). Transactions move fairly quickly so it is important to know that you are with the lender that will close the transaction rather than risk losing the transaction.
During the pre-approval process, the buyer will submit the following information to the bank:
a) copies of their last 3 years tax returns
b) authorize a credit check
c) provide a copy of their resume
d) complete an SBA Personal Financial Statement and Application
The buyer will be asked to sign a LOI from the bank which will indicate the proposed loan amount, down payment, and loan terms. When the LOI is signed the bank will require a deposit to start the business valuation, collateral appraisals, and underwriting.
The lender will evaluate the business financials to determine the net after debt service, cash flow and generally does it support the deal. Next underwriting considers if the business net after debt service supports the buyer’s income needs. Finally, underwriting obtains appraisals on the business and the buyer’s collateral (usually their personal residence).
- Final Approval and Closing!
When underwriting is complete and approved and the appraisals are complete the Buyer will receive a Final Approval letter. When this is signed by the buyer the bank will fund the transaction within 5 to 7 days and escrow will close.
At Pacific Business Sales we believe SBA financing provides sellers and buyers with the best transaction financing. SBA financing is our preferred transaction structure for deals under $5 million (SBA financing limit) and has proven to be a win-win for both buyer and seller.
COVID Relief Act has 6 Months No Payments on New SBA Loans in 2021; plus PPP 2021!
Great news for business owners-sellers and business buyers in 2021!
6 Months No Payments on New SBA Loans from February thru September 2021 plus PPP Loan Program 2021!
The COVID Relief Act passed in December 2020 has reinstated the 6 months of loan forgiveness on new SBA loans funded between February 1st, 2021 and September 30th, 2021. This means a buyer using SBA financing will not have any loan payments for the first six months after closing and the principal and interest due will be paid by the SBA (essentially forgiven). Pacific Business Sales are Orange County Business Brokers specializing in e-commerce businesses for sale in Orange County and we work exclusively with SBA PLP (Preferred Lending Program) banks. Learn more about how Pacific Business Sales can help sell your e-commerce business for max value.
For example, a $1 million SBA 7a loan at 5.75% (SBA rate as of December 2020), the monthly payment is $10,976.92 and the buyer would save $54,000 (loan forgiveness is capped at $9,000 per month).
Obviously, this saves buyers 6 months of loan payments and equally importantly it gives buyers 6 months to build working capital through increased cash flow as a result of no loan payments.
In 2020 Pacific Business Sales closed many transactions with this program and it was responsible for substantially increasing business sales and SBA loan activity until it ended in September. We expect this program to do the same for 2021 business sales and SBA loans. 2021 is already shaping up to be a very business year for business sales. For more tips, such as why we suggest using a standard purchase agreement for e-commerce business sales, view our blog.
UPDATE: SBA 7a Guarantee Fee Waived & 3 Additional Months Loan Forgiveness on 2020 Loans
The final COVID Relief Act may include a waiver of the 3%, or 3.5% for loans over $750,000, SBA 7a loan guarantee fee paid by the buyer. On a $500,000 SBA loan, this is a savings of $15,000, and on a $1 million SBA loan, this is a savings of $35,000! We should have confirmation of this by early January.
The COVID Relief Act also includes an additional 3 months of Loan forgiveness for qualifying SBA loans funded in 2020 that had 6 months of loan forgiveness.
More Great News, PPP 2021
The COVID Relief Act also includes funding and rule changes (good ones) to the popular PPP program. There is a Round 2 of PPP and business with 2020 sales that are 25% lower than the same quarter in 2019 qualify.
A few more details below…
- 2020 sales 25% lower than the same quarter in 2019 qualify.
- Business less than 300 employees
- Simplified loan forgiveness for loans under $150,000
- 2.5 months average 2020 payroll for loan amount
- Must use 60% for payroll and 24 weeks to use the funds
- Additional expense categories allowed for the other 40% use of funds
List of FinTech Companies Offering PPP Loans
Most small business owners had difficulty obtaining PPP loans from their own banks if they banked with one of the big national banks. Many were able to get PPP loans more quickly through local or regional banks and FinTech companies. Below is a list of FinTech companies that offered PPP Loans during the 2020 PPP program.
NOTE the SBA has not provided the banks with the guidelines or complete program information yet and the lenders will probably not be ready to start taking applications until mid-January 2021.
- Kabbage https://www.kabbage.com/paycheck-protection-program-loans/
- Veem https://www.veem.com/sba-ppp/
- Biz2credit https://www.biz2credit.com/
- Lendio https://www.lendio.com/
- Fundera https://www.fundera.com/
- Divvy https://getdivvy.com/covid-19/sba-ppp-loans/
- BlueVine https://www.bluevine.com/sba-cares/
- OnDeck https://www.ondeck.com/resources/what-is-the-paycheck-protection-program
- Funding Circle https://www.fundingcircle.com/us/paycheck-app-start/
- NAV https://app.nav.com/paycheck-protection-program-form
- Ready Capital https://ppp.readycapital.com/
- Cross River Bank https://www.crossriversba.com/
- Square https://squareup.com/us/en/l/sba-ppp-loans
- Paypal https://www.loanbuilder.com/ppp-loan-application
- Intuit(Quickbooks) https://quickbooks.intuit.com/small-business/coronavirus/paycheck-protection-program/
- Credibly https://sba.credibly.com/apply-online
- Brex + Womply https://www.womply.com/brex/
- Fundbox https://fundbox.com/paycheck-protection-loan/
Details on SBA Loans and PPP Round 2 in COVID Relief Act of 2020/2021
Section 325: Extension of Section 1112 Payments, the debt relief program.
Provides $3.5 billion in funding for extension of Section 1112 payments—appropriations available through September 30, 2021.
- Resumes the payment of principal and interest (P&I) on small business loans guaranteed by the SBA under the 7(a), 504 and Microloan programs, established under Section 1112 of the CARES Act.
- Provides that all borrowers with qualifying loans approved by the SBA prior to the CARES Act will receive an additional three months of P&I, starting in February 2021. Going forward, those payments will be capped at $9,000 per borrower per month.
- Provides that, after the three-month period described above, borrowers considered to be underserved—i.e., the smallest and hardest-hit by the pandemic—will receive an additional five months of P&I payments, also capped at $9,000 per borrower per month. These include:
- Borrowers with SBA microloans or 7(a) Community Advantage loans
- Borrowers with any 7(a) or 504 loan in the hardest-hit sectors, as measured by the severity of sector-wide job losses since the start of the pandemic, including all those belong to 2- and 3- digit NAICS categories with the most severe job losses since the start of the pandemic: accommodation and food services (72); arts, entertainment, and recreation (71); educational services (61); mining and logging (213); apparel (315); clothing and clothing accessory stores (448); sporting goods, hobby, book, and music stores (451); air transportation (481); transit and ground passenger transportation (485); scenic and sightseeing transportation (487); publishing industries, except Internet (511); motion picture and sound recording industries (512); broadcasting, except Internet (515); rental and leasing services (532); and personal and laundry services (812).
- Provides SBA payments of P&I on the first 6 months of newly approved loans will resume for all loans approved between February 1 and September 30, 2021, also capped at $9,000 per month.
- Specifies that if the SBA projects that appropriations provided for the debt relief program are insufficient to fund the extensions provided, the Administrator may proportionally reduce the number of months provided in each extension.
- Clarifies eligibility and increases program integrity:
- SBA payments should be made on any loan approved before the applicable deadline, and debt relief payments should be made only once the loan is fully disbursed.
- SBA may establish a minimum loan maturity period for each loan product covered under this section to prevent program abuse.
- Any business or applicant may only receive P&I payments for only one loan approved after CARES Act enactment.
- Requires that SBA place program information on its website, conduct outreach to all borrowers, report monthly to Congress on program spending, and educate lenders, borrowers, SBA district offices, and resources partners about the program.”
UCLA 2021 Economic Forecast, Get Ready for the Roaring 20’s!
UCLA economists are predicting an economic rebound in 2021 after a few weak months in early 2021. Basically it will be a continued gloomy COVID winter, with a spring rebound starting off the recovery. This is good news after a turbulent 2020 for the US economy and it’s great news for the California economy as UCLA is projecting California to grow faster than the rest of the US.
The forecast expects California’s tech industry, healthcare, and construction to be the fastest growing in 2021 with retail, food, and hospitality businesses suffering a prolonged hangover from the 2020 shutdowns. Pacific Business Sales is a top rated construction business broker in Orange County.
The forecast predicts construction of single family homes to rebound quickly to 123,000 new units, a 16% increase, due to a lack of supply, pent up demand and low mortgage rates. Contact Pacific Business Sales today for more information on selling your Orange County construction business.
While the outlook for new home construction is bright, the UCLA 2021 forecast is warning of possible slow downs in commercial construction due to reduced demand in the short term. The forecast also warns of possible state/local government construction projects slowing due to budget constraints, however, this could be offset by Federal infrastructure projects and stimulus to prop up the economy by the Biden Administration.
For the latest news on business sales, such as Google reviews affecting the sale of Orange County construction businesses, follow our blog.
Why use a Standardized Purchase Offer or LOI to Sell or Buy a Business vs Custom Agreement
Purchase Agreements for e-commerce businesses for sale in Orange County are either Asset Purchase Agreements, Stock Purchase Agreements or LOI’s (Letters of Intent). There are effectively two choices when buying or selling a business with respect to purchase agreements. A buyer can opt to have their attorney draft the purchase agreement from scratch or use a standardized purchase agreement such as the one created by the California Association of Business Brokers (CABB).
While some buyers may initially find comfort in using an attorney to draft a custom agreement for the transaction, the feeling will be gone when they receive the bill. The cost for an attorney to draft a purchase agreement or LOI will certainly be several thousand dollars and if there are revisions and amendments as a result of negotiations that bill will continue to climb. On one transaction in which the buyer insisted on using an attorney to draft an LOI and the purchase agreement their legal fees were over $40,000. While this is an extreme example, once they went down this path there was no turning back. The transaction was successful, just very expensive on their part. Pacific Business Sales specializes in selling e-commerce businesses in Orange County for max value.
Thousands of businesses are sold every year and while the businesses are all very different, the transaction process is the same for each business. Much like CAR (California Association of Realtors) created standardized purchase agreements and associated forms, CABB (California Association of Business Brokers) has done the same for business sales.
The CABB purchase agreements were drafted by attorneys that are Associate Members of CABB alongside CABB’s most experienced Business Brokers. Their objective was to produce standardized agreements for business sales likened to residential and commercial real estate purchase agreements produced by CAR and AIR (Association of Industrial Realtors).
Using the standardized agreements are advantageous in four ways
- The CABB forms and agreements are written to include the majority of components in an asset or stock sale and have protections built-in for both buyer and seller. The contracts are easily read and in the case of a stock sale form the foundation of the purchase agreement for your attorney to review rather than creating an entire document from scratch (which you are billed for). If you choose to use an attorney they can add an addendum with any additional terms or language they feel is required.
- If a buyer hires an attorney to write a LOI or purchase agreement the cost could become prohibitive especially if the LOI or purchase agreement is not accepted. Remember, while you have paid for that offer or LOI to be drafted, there is no assurance it will be accepted or if accepted the deal will go through. You will have a lot invested just to present an offer or LOI. If the terms are acceptable to the seller then the seller needs to engage their attorney to review before acceptance. And if the seller’s attorney comes back with revisions, then it goes back to your attorney to review the revisions, and perhaps counter some of the revisions. And on and on…
- If a custom purchase agreement, LOI or contract is written by an attorney the broker cannot give legal advice and has to advise both parties to seek advice from their attorneys. The legal costs can run into the thousands of dollars before the transaction begins, if it begins.
- Many attorneys are not familiar with the nuances in the small and midsize business sale transaction and leave important components out of the LOI or purchase agreement which again will add additional costs through amendments and review.
At Pacific Business Sales we use the standardized CABB forms and purchase agreements for practicality, consistency, and legal cost savings for the buyer and seller. The CABB forms and agreements are written by attorneys and experienced business brokers specifically for small-midsize business sales. The forms are comprehensive and many buyers on straightforward transactions opt not engage an attorney. We advise clients to have their attorney review the purchase agreements if they have any legal questions that would need to be addressed by an attorney.
Where an attorney is especially useful and required is preparing specific agreements such as a consulting agreement with the seller. We also recommend sellers have their attorney draft the seller note and security agreement.
At Pacific Business Sales our goal is making the transaction go in a smooth and timely manner.. We walk buyers and sellers through the selling process from beginning to end, explaining every step of the transaction. For the latest news, including COVID relief for e-commerce business sales in Orange County, read our blog.
Market Update, Effect of COVID19 on Business Value and Sales
COVID 19 has impacted our daily lives and how businesses are run. It has changed the way we do business on a daily basis on a local, national and global scale. What does that mean for business value, how are the sales of businesses being affected, and how does it affect buyers and sellers?
There are many businesses in the retail industry such as restaurants, retail stores and personal services that have had to shut down or dramatically scale back operations resulting in limited to no revenue during the Stay at Home orders. PPP loans, SBA EIDL (Economic Injury Disaster) loans and/or personal savings have kept these businesses going.
Other businesses that are considered essential and allowed to continue operations. These ranged from industrial to manufacturing and distribution businesses, construction services, grocery stores and medical, healthcare providers. The owners of essential businesses saw their revenues either stay the same or have a modest decrease during this time allowing them to stay on the market and sell. Some businesses such as construction and military manufacturing have seen an increase in business during COVID-19. Another business segment that has been unaffected by COVID-19 has been ecommerce which has continued to have solid performance during the pandemic.
Business in the essential services categories or those that have been unaffected by COVID-19 have seen strong demand from prospective buyers, SBA lenders have continued approving acquisition financing, and we are having a very strong year for business sales at Pacific Business Sales. Business Values for these businesses have not been affected by and the valuation multiples of DE (Discretionary Earnings) and EBITDA remain the same as they historically have been.
Businesses that have had an economic impact from COVID-19 have generally been pulled from the market with the owners choosing to wait until the business recovers. The good news here is that we have been on numerous conference calls with SBA Lenders and Business Valuation Analysts (appraisers) discussing how these businesses will be valued going forward and there is a plan and methodology in place.
The methodology to value a business that has been affected by COVID-19 will be to normalize the COVID-19 period using historical financial data and use projections for the rest of the year and following year. This of course would be used for businesses that are emerging from the shut down and showing signs of recovery.
From a “buy side” perspective the market is still very strong with buyers focusing heavily on businesses either unaffected by COVID-19 or minimally affected. There are buyers for distressed sales and there will be buyers businesses affected by COVID-19 as they recover. We are seeing a wave of corporate expatriates that have either been laid off, had salaires reduced or are facing the prospects of this. These buyers are motivated to buy a business to secure their future and leave the corporate rat race.
The market is still strong for essential businesses and moving forward the businesses that saw a drop in their revenue during this time with a return to normal sales volumes will be able to sell their business with little to no effect on the value of their businesses.
Businesses are still selling and sellers are still able to receive maximum value for their businesses despite COVID-19.
Additional Information about Selling a Small Business
How to Buy a Business with a Business Broker
Are you thinking about buying a business to build your future, gain personal freedom and independence but not sure where and how to start? How do you get started and find the right business? What are the steps involved to find the best business for you?
Before you start your search for the right business, we suggest you step back and look at what types of businesses are for sale. It will surprise you how many different types of businesses there are. We also recommend keeping an open mind with respect to business types and look at broad industries, even look at some that you had not necessarily considered.
- Search & Identify Prospective Businesses:
The first step involved is to search the businesses for sale listing sites such as Bizbuysell.com, Bizben.com, CABB.org etc. There are a wide range of businesses available at any given time in a variety of industries. You will be able to search by industry and location plus the amount of earnings and price that fits your financial situation.
- Get Your Finances & Financing Together:
Before you inquire about a business for sale get your finances in order. How much cash do you have for a down payment? Remember you will also need working capital for operating expenses, closing costs etc. If you are going to use SBA financing (which we highly recommend) you will be able to leverage your down payment to buy a much larger company. See our SBA financing page for more information on using SBA financing to buy a business.
- Inquire about the business:
When you find a business that you are interested in, submit an inquiry from the listing site and you will be sent a Confidentiality Agreement and Buyer Profile to fill out and sign. Your inquiry will usually go to the listing broker for the business. Make sure you fill out the Buyer Profile completely, including providing the requested financial information. Brokers will not provide any confidential information about the business for sale without a complete Buyer Profile and if you do not provide financial information they will assume you are not qualified. The majority of business sales are Dual Agency transactions, which means the broker represents both buyer and seller in the transaction. This is common in business brokerage.
- Sign NDA & Receive Confidential Information Memorandum or Business Profile:
After you have signed the confidentiality agreement and buyer profile the broker will review both to determine if you are qualified to purchase the business. If everything is signed and you qualify you will be sent a Confidential Information Memorandum (CIM). The CIM should have enough information in it for you to determine if you are interested and want to move to the next step. Be careful not to rule out a business too quickly because the business profile (CIM) lacks detail. While our firm, Pacific Business Sales, prepares comprehensive business profiles, most brokers prepare a very brief overview of the company. If the company looks interesting, give it the benefit of the doubt and contact the broker for more information.
- Contact Broker for more info:
The next step is to contact the broker that provided you with the CIM to discuss the opportunity, provide your background, and if you are interested ask the broker to set up a meeting with the seller to further discuss the business. Again, if it looks interesting, go ahead and set up a meeting. Buyers often have the expectation that everything they need to know will be in the CIM or obtained in a quick phone call with the broker and often prematurely pass on a business without really learning about it. You won’t buy a business from your laptop in your pajamas at home, you have to go to the business, meet the owner, and learn about it.
- Seller Meeting & Visit Business:
At the seller meeting you will be able to discuss the operations of the business, the sellers role, customer concentration, marketing, employees and their rolls, and general questions about financials such as average inventory, A/R and backlog. There may be other questions depending on the type of business and industry. The first meeting is not the time for asking detailed questions about the financials and tax returns or to start asking the seller to prove his figures, that is done after an offer is made during due diligence. During Due Diligence you will have full access to the company financials and plenty of time to drill down into the details to prove the revenue and earnings of the business. Note in many cases there may be more than one Seller meeting. Consider the first one an introduction and the second one is where you learn more about the details of the business.
- Write an Offer:
After your Seller meetings and perhaps some additional phone calls with the broker you will have enough information to write an offer for the business. The broker will sit down with you and go over the contract and guide you through the process. The broker will discuss the down payment options, the best lenders for the transaction if you are using SBA financing, and Stock vs. Asset sale, transaction structure and timeline. We highly recommend using an industry standard Purchase Offer such as the California Association of Business Brokers (CABB) Asset Purchase Agreement or Stock Purchase Agreement.
- Broker Presents Offer:
When you have completed and signed the Purchase Agreement your broker will present the offer to the seller. If the Seller sends a Counter Offer the broker will review it with you. Note that with the offer you will provide the broker with an Earnest Money deposit. This deposit is usually held uncashed until you have removed your Due Diligence contingency in writing at which time the deposit will be sent to escrow to formally open escrow.
- Offer Accepted, Due Diligence Starts:
Once the offer is accepted by both parties Due Diligence starts. You will be asked to provide a due diligence list of the information you wish to review. This typically includes bank statements, 3 years of tax returns, employee info, etc. Due Diligence typically takes 2 to weeks once you have received the information and the timeline is specified in your offer. On small businesses it is common for the buyer to do their own Due Diligence review. In some cases buyers may elect to have a CPA assist them with the financial review and on stock sales or larger transactions buyers sometimes also engage an attorney to advise them. Regardless of if you engage professional advisors or not, at the end of the day, it is your decision to buy the business or not. We highly recommend buyers to be directly involved in Due Diligence and not to solely rely on advisors.
- Due Diligence Complete & Escrow Opens:
When you are satisfied with due diligence escrow is opened and your broker will provide you with a closing checklist in addition to the closing checklist from the bank and escrow. If you are using SBA financing the bank will have a long list of documentation required and lots of paperwork. We recommend starting the SBA application as soon as possible as this is the longest lead time item.
- Escrow Closes:
Once your loan is approved and everything escrow needs is completed the transaction closes and you now own your own business.
- Training Starts:
Training starts after the close of escrow. Your Purchase Agreement will have a training period specific with a number of weeks and hours per week that are included in the purchase price. This is typically 4 weeks, sometimes up to 6 or even 8 weeks. This is negotiable but keep in mind that Sellers do not want to provide extended training for free, especially if the price was less than full price. A consulting agreement is often included in the Purchase Agreement for extended training at a specified price.
During and after training remember you have bought a business that has been successfully operating for perhaps 20 or 30 years. We recommend avoiding the temptation to immediately start “fixing” or improving things as the new owner or boss. Remember there is likely a lot of loyalty to the old owner and employees know the current systems. Often there are reasons for the way things are done that you may not immediately understand. Learn the business from the owner, be patient, and only implement changes after you thoroughly understand the entire business from front to back.
For more about how to buy a business preview my book, “Own your Future, Straight Talk about Buying a Business and Building Your Future.”
How to Value a Small Business Using Earnings Multiples
A business owner or prospective seller may want to know the value of their business before deciding to put it on the market. Buyers may wish to calculate the value or compare the asking price of a business they are interested in. In the case of business owners considering the sale of their business most business brokers offer a free Market Value Analysis and in fact our firm offers a comprehensive Business Market Value Analysis to prospective sellers. In either case, the simplest method to obtain an approximate business value is to use the Earnings Multiple method (also known as Market Data, Comps, Discretionary Earnings or DE Multiple).
Most business buyers and sellers/owners are somewhat aware of earnings multiples but few understand how to properly use and apply these multiples to value a business. There are many myths and opinions about what a business is worth and what “the” earnings multiple is. In fact earnings multiples vary widely by industry as well as by earnings. There are different multiples for Discretionary Earnings (DE aka SDE or Seller’s Discretionary Earnings) and EBITDA (Earnings Before Interest Taxes Depreciation & Amortization). DE multiples are lower than EBITDA multiples because with DE you are multiplying a higher earnings number against a lower multiple and with EBITDA you are multiplying a lower earnings number against a higher multiple. Ideally you should get roughly the same value for both approaches. There are no valuation multiples for “net profit” for a small-midsize business and simply applying say a DE multiple to Net Profit will result in a dramatically undervalued figure for the business. As explained below, the Net Profit does not reflect the actual earnings of a small business, thus using it for valuation purposes is meaningless.
While Earning Multiples seem like a simple method to value a business, and they can be, they must be used correctly and on the right earnings value to deliver the correct valuation for a business.
Discretionary Earnings vs Net Profit vs EBITDA
First you need to understand the difference between each earnings type and how to calculate them, then look at how to apply them.
- Net Profit:
This is the starting point for calculating both DE and EBITDA. When a business broker or valuation analyst refers to Net Profit this is the Net Profit shown on the company tax returns. The Net Profit on the company P&L is often different from the Tax Return Net Profit as a result of changes made by the accountant or CPA at year end which were not reconciled with the P&L. The Tax Return Net Profit is the only figure used for valuation purposes (note that SBA lenders and valuation analysts only use the Tax Return Net Profit).
EBITDA is actually simple to calculate. Start with the Net Profit from the Tax Return and add the Interest, Taxes, Depreciation, & Amortization. This is the non-normalized EBITDA and for very large businesses this figure is correct.
For small businesses, you must first add back all of the owner’s benefits & compensation and then subtract a replacement salary for the owner at market rate. This would be the salary of a manager to run the business inplace of the seller. This is called Normalized EBITDA which is used for small businesses. A simple way to determine Normalized EBITDA is to take the DE and subtract a replacement salary for the owner at market rate.
- Discretionary Earnings (DE):
DE is the most commonly used valuation multiple and it is also the most complicated figure to calculate. DE basically is EBITDA + owners salary + owner’s benefits & expenses. This sounds simple enough and it would be except that many owners bury these expenses which can make it difficult to verify these figures. One key rule for owner’s expense add-backs is that they MUST be tied to an expense line item on the tax return. If the expense is not shown on the tax return then it cannot be used as an add-back for calculating DE as it was not shown as an expense on the tax return, which is what is used to calculate DE.
Finding the Right Earnings Multiple for a Business
You can get Discretionary Earnings multiples and Business Valuation Reports from BizBuySell and Peercomps. BizBuySell offers valuation reports from $19.95 to $59.95 and Peercomps offers a one time comps search for $49 or a one time business valuation for $99.
The BizBuySell valuation is the simplest to use and the least expensive. While it is good for determining a price range, the downside is that it is not an accurate valuation program. You should only use it for validating a price range and not for determining an exact business value. Note that the comparable sales data in BizBuySell is broker provided, meaning that brokers input this data when a business is sold through BizBuySell. There are thousands of transactions in the database, the problem is that the way brokers record transactions can vary, making the data less consistent than Peercomps.
The Peercomps valuation is more comprehensive and uses better comparable sales data as their database is from actual closed SBA financed transactions. All SBA loans require an independent (third party) business valuation (appraisal) by a CVA (Certified Business Valuation Analyst). Thus this comparable sales data is more accurate and more consistent than broker provided comps. The downside of Peercomps is that it is much more complicated to use and obtain an accurate valuation. The user should be familiar with valuation methods in order to use Peercomps.
Steps to Finding Earnings Multiple Comparable Sales Data
- In BizBuySell or Peercomps select the Industry-Business Type (e.g. Distribution, Restaurant, Manufacturing, Construction – note that you can select more specific business types)
- Narrow the Gross Sales and Income ranges to values below and above the company’s annual revenue and income. Set a minimum value to eliminate businesses much smaller than the company you are considering and a maximum to eliminate businesses that are much larger.
- You can change the ranges to narrow or expand your results until you have a suitable number of comps (preferably at least 5 to 10 or more. In some cases there may be very few if it is a small niche).
- Now you should have comparable sales multiples for Discretionary Earnings and if you used Peercomps Normalized EBITDA as well. The next step is to apply the multiples
- Most DE multiples do not include inventory or A/R (Accounts Receivable) and also assume that all liabilities are paid off by the Seller at closing.
- Peercomps multiples include “normal” inventory and BizBuySell comps may or may not.
- Normal inventory is the inventory required to operate the business. Excess inventory is not included in the earnings multiple.
Applying the Earnings Multiple to Determine Business Value
If you are using the valuation report from BizBuySell or Peercomps you can input the company earnings and revenue to obtain a value based on the Mean or Average Discretionary Earnings multiple. If you elected to obtain comparable sales data only your next step is to multiply the Mean or Average DE multiple to the DE you calculated. This will give you a value based on the Mean or Average multiple.
It is important to note and understand that the figure you just calculated is not an exact figure. The multiple you just used is an average. Thus, half of the businesses in the comps sold for less than that multiple and conversely half sold for more than that figure.
If you are considering a business that is exceptional it may be worth a premium and the average multiple may be on the low side. Likewise, if the business is below average it may be appropriate to apply a discount.
7 Factors that Affect Business Value and Earnings Multiples
- Quality of Financial Data
- Quality of Product or Service
- Years Established
- Quality & Experience of Staff
- Infrastructure, Systems, Procedures
- Customer Concentration
Earnings Multiples are a convenient and relatively simple way to calculate business values, but as we discussed above, it is not an exact value and more of an average value. If you are buying a business the Business Broker should have a Recast Financial Statement showing the financials from the Seller’s tax returns and all of the add backs to arrive at the Discretionary Earnings. The Broker should also be able to provide you with Comps Data and a Market Value Analysis.
If you are Selling your business we recast your financial statements and prepare a comprehensive Market Value Analysis as part of our initial review of the business to determine the asking price.
INFORMATION ON BUYING-SELLING A BUSINESS
What Questions Should I Ask the Seller About His Business?
As a Business Broker one of the most irritating things I see buyers do is spend an hour meeting with a seller and walk away knowing very little about the business. How does a buyer spend an hour with a business owner and learn almost nothing about the business?
Many buyers focus on the P&L and financial statements almost exclusively, asking questions about specific expenses, depreciation (which most sellers have no idea about since their CPA calculates this), Cost of Goods Sold, etc. While these questions are appropriate and necessary during Due Diligence, in the early stages of considering a business they provide zero insight into the actual business itself. Consequently when a buyer spends (wastes) their time focusing exclusively on financial questions they walk away with no understanding of the business. Who are the customers, what is the owner’s role and daily activities, what do the employees do, what experience do the employees have, what is the competitive edge the company has, what marketing does the company do? These questions give you insight into the business, it’s products/services, infrastructure, and operations.
Ask these 7 Simple Questions to Learn Everything About a Business You are Considering Buying
When you meet with a business owner/seller ask them open ended questions. Business owners are very proud of their business and most love to talk about it. By asking general questions you start a dialogue where you will learn all about the business and the owner.
- Tell me about your business…
- I’d like to know more about your products/services…
- What are your daily activities in the business? What are your primary roles?
- What are your employees responsibilities? Tell me about their experience…
- What does your company do for marketing?
- Are there any customers that represent over 20% of your annual sales?
- I would like to know your ideas and suggestions for what I could do to grow the business…
The goal of your initial meeting with the Seller is to learn as much as possible about the business and the owner. Is this a business you can see yourself running? How dependent is it on the owner? What’s the owner like? What are the employees like and what is their experience? By asking open ended questions about the business all of this will come out naturally during the discussion and you will gain much more insight into the business than you do from simply asking questions about the P&L.
INFORMATION ON BUYING-SELLING A BUSINESS
5 Signs a Business Purchase is a Bad Deal and When to Walk Away
Finding the right business is a long and challenging process for prospective buyers; when a buyer finds a promising business sometimes it is hard to walk away from the deal. They’ve likely invested a lot of time into the deal and are emotionally attached to it. At that point buyers will really want to find a way to make the deal work. Often hard work and perseverance pays off and it all works out, but there are times when you should walk away.
When to Walk Away from a Business Purchase Transaction
- Seller is Difficult:
There are many difficult people in the world. If the seller you are working with is one of them and you can’t work constructively and productively things will not go well. You will need this seller to train you and you will be relying on him to be cooperative and committed during the transaction and more importantly during transition and training. If the seller is difficult to work with it will be nearly impossible to have a smooth transaction and the deal may fall apart later anyway.
- The Numbers Don’t Make Sense:
If the figures on the financial statements don’t make sense and cannot be explained to the satisfaction of you or your CPA it may be time to walk. While there are many good businesses with imperfect books & records/financial statements, the seller and their CPA should be able to explain them to your satisfaction during your meetings and prove it to your satisfaction during Due Diligence. The trick here is to determine where that line is and when it’s time to walk away.
- Cash Flow Doesn’t Pencil Out:
If the cash flow after debt service and your required income is not meeting your needs you should seriously consider passing on the business. While you can grow the business and make improvements, it will take time. If the business will meet your needs in the interim that’s fine, but if it is far short of your income needs you should pass on this one.
- Poor Books & Records:
If the books & records and financial statements are poor it is nearly impossible to verify the actual earnings of the business. In situations like this you are flying blind with respect to how the business is performing financially. Some owners have poor computer records, but good paper records (yes, paper records even today). In these situations it is possible to verify the revenue and income, it is just a lot of work. It’s your decision as to if it is worth the work and if you can adequately verify the figures.
- The Seller is Evasive or Untruthful:
If the seller is evasive or untruthful you should walk away, in fact, run away from that deal. If the seller is not forthcoming and open with information it is very difficult to learn the facts about the business and if they are untruthful then you have no way of knowing what is real and what is fiction. It’s difficult to conclude a transactions successfully if the Seller is not open and willing to provide detailed information.
Working with a reputable experienced business broker will definitely be an advantage in finding the right business to buy. An experienced business broker will be able to facilitate the transaction process and coach a buyer on the above problem areas. From the initial meeting through closing a business broker should be able to have or get all of your questions answered and let you know where there might be a potential problem.
Not all problems are deal killers and there are many times when a solution can be reached. However, there are times to walk away because the risk of buying that particular business can be too high.
INFORMATION ON BUYING-SELLING A BUSINESS
Preparing for Due Diligence on the Sale of Your Business
After an offer for your business has been made and accepted the next step is Due Diligence where the buyer will review the books and records of the business to verify the revenue, earnings and veracity of the business. Due Diligence is a Contingency for both Buyer and Seller; the buyer’s deposit check is not cashed and Escrow is not opened until after both buyer and seller have removed this contingency. When the Due Diligence Contingency is removed the Business Broker will send the Purchase Agreement documents and buyer’s deposit check to Escrow. Escrow will deposit the buyer’s earnest money deposit check into their trust account, draft the escrow documents, and once these documents are signed Escrow is opened.
During the Due Diligence process the role of your Business Broker is to organize and facilitate the process and most importantly keep it on track. The buyer and seller may engage other advisors (see below) to assist and advise them during the Due Diligence process. Pacific Business Sales specializes in preparing for Due Diligence for manufacturing businesses for sale in Orange County.
Due Diligence Timeline
Due Diligence typically takes 3 weeks for a small to midsize business and can take longer for larger or more complicated businesses; or if the records and business information is not readily available from the seller. At Pacific Business Sales we use the CABB (California Association of Business Brokers) Purchase Agreements for both business Asset Sale and Stock Sale transactions. The CABB agreement breaks Due Diligence down into three steps shown below with the number of calendar days specified for each step. The number of days is specified by the buyer when the offer is prepared with the Business Broker. Ask us how we can secretly sell your Orange County manufacturing business.
- Buyer Due Diligence List: typically 3 to 5 days
- Due Diligence Materials Provided: typically 5 to 7 days
- Review of Due Diligence Materials: typically 10 to 14 days for small to midsize transactions, may be longer for larger or more complex transactions.
- Total number of days for Due Diligence: typically 20 to 30 days.
At the conclusion of the Due Diligence period each party removes the Due Diligence Contingency and the broker will open escrow. Should either party decide not to remove the Due Diligence Contingency the transaction is terminated and the buyer’s deposit is returned in full (see Wrapping Up Due Diligence below).
Typical Due Diligence Items
Below is a typical Due Diligence list for a small to midsize business. Note that different businesses and industries will have additional items specific to that business or industry and the buyer’s CPA or financial advisor may have additional items they wish to review. If the transaction is a Stock Sale, there will be additional items relating to corporate records that require review.
- Seller Disclosure Statement (part of CABB Purchase Agreement).
- Business Tax Returns, last 3 years.
- Sales Tax Returns (if the Seller has a resale account).
- Bank statements (month by month), last 3 years and year to date.
- Last 3 years P&L statements.
- Balance Sheets for last year end and most recent month end.
- Sales by product or service type/category.
- Customer list (note in some cases this may be redacted for confidentiality).
- A/R and A/R aging report.A/P report.
- Employee list with roles and responsibilities.
- Payroll reports for last 2 or 3 years with W2s.
- Inventory and inventory reports.
- Workman’s Comp policy, mod rate, and claims report.
- General Liability policy.
- Current Lease.
- Equipment list.
- Buyer’s CPA may have additional items requested for review.
- Note that lien searches, releases from state agencies including EDD, Franchise Tax Board, and Dept of Fees (formerly State Board of Equalization), and public notice to creditors are done by escrow once escrow is opened.
Due Diligence Advisors
In many transactions, the buyer and seller opt to conduct the Due Diligence review on their own. This is typical for small transactions where the financial statements and other records are straightforward. Some buyers may engage a CPA to assist them with the financial review and if the transaction is a Stock Sale the buyer may also engage an attorney to review the corporate records. Likewise, some sellers may need to engage their CPA or accountant to provide the requested financial information to the buyer and answer questions about the P&L, Balance Sheet, expenses, tax returns, and owner benefits/expense add backs.
- CPA or financial advisor representing the buyer if buyer opts to engage one.
- Seller’s CPA, accountant or bookkeeper to answer questions about financial statements.
- Buyer’s attorney if buyer opts to engage one (typically for larger transactions and on Stock Sales). The buyer may also use their attorney to draft a consulting agreement with the seller or other specific agreements if required.
- Seller’s attorney if required such as in a Stock Sale to do the stock certificates and stock transactions.
- Buyer and seller’s insurance brokers.
The Business Broker representing the seller and/or buyer if they are a dual agent cannot act as an advisor to either party with respect to Due Diligence as they are not a CPA or accountant and cannot provide financial or legal advice to either party. The broker can facilitate the Due Diligence process and assist buyer and seller in organizing the process and answer questions relating to the transaction.
Seller’s Due Diligence
Much of the focus of Due Diligence is on the buyer side, but there is also a seller Due Diligence contingency. During the Due Diligence period the seller has the opportunity to review the buyer’s qualifications, financial wherewithal to complete the transaction and ability to run the business. Typical seller Due Diligence items are:
- Buyer Resume.
- Buyer Disclosure Statement (part of CABB Purchase Agreement)
- Buyer Personal Financial Statement (often a copy of their SBA loan application).
- Source of Funds.
- Background Check (this is not always requested but can be).
Wrapping Up Due Diligence
At the end of the Due Diligence period the Business Broker will send buyer and seller a Due Diligence Contingency Removal and Authorization to Open Escrow document for signature. When the Contingency Removal is signed the broker will send the purchase agreement documents and buyer deposit check to escrow to draft Escrow docs, obtain signatures and open Escrow.
If the parties require more time both can agree, and the broker will write an addendum to the Purchase Agreement extending the Due Diligence period.
If the buyer has found problems during Due Diligence the first step is to review the issues with the seller. Often the perceived issues are either a misunderstanding of the financial statements, a result of missing information, or a minor issue that is resolved after review with the seller.
If the issue is significant there are three options 1) negotiate an accommodation with the seller which may involve price or terms, 2) accept the agreement as is if the issue is not significant, 3) terminate the agreement in which case the buyer’s deposit check is returned in full and the transaction is cancelled.
Due Diligence is perhaps one of the most important steps in purchasing a business, second only to the actual purchase agreement and negotiation. With the help of a professional Business Broker to prepare and negotiate the offer and facilitate the process you can look forward to a timely and successful transaction. Learn more about how Pacific Business Sales can help you sell your Orange County manufacturing company for maximum value!