Buying and Selling a Small Business - Chapter 8 - Financing and Implementing the Transaction

Compliance With the Bulk Sale Act

Noncompliance or inadequate compliance may result in attachment of the property after the sale by creditors of the seller and voiding of the buy-sell transaction. The buyer should not close the transaction until he has made sure that all statutory requirements have been met.

Financing the Buy-Sell Transaction

The other basic form of financing is through borrowing or the establishment of credit. This method of financing may or may not require the payment of interest, but it does require the borrower to repay the principal, usually over a stipulated period of time or on a specific date. This method of financing is commonly referred to as the use of debt capital. Often the purchase is made through a combination of equity and debt capital.

Equity capital. In the simplest form of purchase, the buyer pays the full purchase price in cash. The buyer's investment in the business, at least initially, is full and complete. Whether the funds come from one person or more than one, the financial nature of the transaction does not change.

The sources of equity capital are many and varied. Generally, they are in the form of bank savings. Or cash may be obtained from liquidating certain assets the buyer may own, such as surrendering life insurance policies for cash value or selling real estate, stocks and bonds, or other assets.

Before disposing of assets, however, the buyer should ask himself this question: "Do I want to buy the business more than I want to keep these assets, considering both present and future values?" For instance, if the buyer cases $16,000 worth of government bonds, there may be a possibility of his making a higher profit, but the risk of losing his investment entirely will be greater. He should be as certain as possible that the expected return is worth the risk.

An equally important question is how much the buyer should invest in the business. In general, the more he invests himself, the better chance he will have of borrowing at least part of the purchase price.

A buyer may not have the capital, however, nor perhaps the inclination, to purchase the business outright with his own personal funds. How far he goes in this respect depends on his own cash resources, his confidence in the business, and his ability to borrow money or establish credit with others.

Debt capital. In most cases, the buyer of a small business will have to borrow money or establish credit to purchase the business. Several factors will affect the use of debt capital for this purpose: the source of capital, the amount that can be borrowed, and the length of time for which the capital can be borrowed.

Commercial lending institutions are the sources to which the buyer will probably turn first. The availability of financing through these sources depends on the security that can be pledged to the loan, the profit potential of the business, the prospect of repayment of principal and interest, and the general availability of credit.

One of the major difficulties facing the buyer at this point concerns the collateral that can be pledged as security. The physical assets of the business--particularly fixtures, equipment, and land and buildings--will not be available for security unless they are free of other financial obligations. The buyer may be forced to look to his own personal assets, such as cash value of life insurance, stocks and bonds, mortgages on real property, and so on.

Less formal sources of debt capital may be open to the buyer, such as loans from friends, relatives, business associates, and the like. Many small businesses have been financed through such means.

The seller as lender. A common source of debt capital is that supplied by the seller when he lets the buyer pay for the business over time. Why should the seller finance the buyer? Probably because the desire to sell is strong enough so that the seller is willing to assume part of the risk.

As in financing from other sources, the seller usually demands that the buyer pay interest on the amount being financed and repay the principal and interest at stipulated periods. The seller usually establishes his security on the more certain assets, such as fixtures and equipment. However, he may also assume the inventory as acceptable security without placing it in a bonded warehouse.

The seller's philosophy toward financing the buyer seems to be that if the buyer should fail, the seller can take back the business. The major problem in this form of financing is that it is harder for the buyer to get additional financing from other sources when the seller has first claim on the assets of the business.

How much to borrow. As the first step toward financing the purchase of a business, the buyer has to find answers to two questions:

"How much do I need to borrow?"
"How much can I afford to borrow?"

The answer to the first question depends partly on how much money the buyer has and how much he is willing to invest in the business himself. The less equity capital he has, the more debt capital he needs.

How much he can afford to borrow depends on his ability to keep up principal and interest payments. If a buyer borrows from a number of sources, he may find himself committed to a repayment schedule that the profits from the business will not support. His borrowing plans should be related to the projected income statement prepared during his study of the business under consideration.

Operating capital. In addition to funds for purchasing the business, the buyer must have enough working capital to cover the cost of operation until the business itself produces enough cash. In other words, the buyer must think in terms of cash requirements and cash flow for weeks and months ahead. A common mistake in buying a business is failure to provide adequate working capital.

If sales and business costs after purchase of the business are expected to follow the pattern of the immediate past, the need for short term working capital should not be hard to estimate.

Closing the Sale of the Regal Men's Store

Critser could pay the entire $84,000 out of cash or negotiable assets converted to cash, providing he had that amount and was willing to invest the entire sum. Critser did not have that much cash and was not likely to be able to raise it.

Critser could pay up to the limit of his own resources and borrow the rest. Critser had been turned down by three banks--they did not consider him an acceptable credit risk. This had nothing to do with Critser's personal credit rating. It was due to concern about whether he could meet the resulting financial obligations out of profits and about the nature of the assets as a basis for security.

Rombaugh could allow Critser to assume ownership of the business and pay the amount due over several years. Whether Rombaugh would agree to such an arrangement would depend on how badly he wanted to sell to Critser, how long it would take Critser to pay off the amount due, and whether there were any other potential buyers who might be able to finance the purchase differently.

Critser might be able to get others to invest with him, forming a partnership and spreading the capital requirements among two or more owners. This arrangement would reduce Critser's ownership in the business, since the legal form would be changed from a single proprietorship to a partnership. Critser did not want this. He would rather not purchase the business than take on a partner.

Critser might form a corporation and sell stock to raise capital. This would not ordinarily be feasible for such a small business.

Plan for Financing the Purchase

Critser's personal investment............................... $40,000
Financed by Rombaugh........................................  34,000
First-year payment: 
Principal at $400 a month...................................  $4,800
Interest at 11.5 percent....................................   3,910
                                                              ------- $8,710 
Financed by Hirschberger....................................  10,000 
First-year payment: 
Principal...................................................  $3,333
Interest at 10 percent......................................   1,000
                                                             -------  4,333 

First-year principal and interest payments.................. $13,043
                                                             -------
Total price................................................. $84,000
                                                             =======

Regal Men's Store

Balance Sheet--February 15, 2005

Assets

Cash on hand and in bank..................................... $4,000 
Merchandise inventory........................................ 47,400 
Fixtures and equipment....................................... 30,000 
Sales and office supplies....................................    600 
Goodwill.....................................................  6,000 
                                                             -------
Total assets................................................. 88,000 
                                                             =======

Liabilities

Notes payable................................................ 44,000 
Net Worth 
Joe Critser, capital......................................... 44,000 
                                                             -------
Total liabilities and new worth.............................. 88,000 
                                                             =======

The decision. In effect, the only course of financing open to Critser was to raise as much as possible, borrow from personal sources, and enlist Rombaugh's willingness to finance the balance. Rombaugh agreed to finance the business to the extent of $34,000, accepting a chattel mortgage on inventory, fixtures, and equipment.

This is somewhat unusual, particularly as to the inventory. There was no requirement that the inventory be placed in a bonded warehouse or otherwise controlled. Rombaugh based his decision on his own knowledge of average inventory value and on his willingness to accept the risk that Critser would not tie up further purchases in accounts payable.

With Rombaugh financing $34,000, Critser now had to raise the remaining $50,000. He got $10,000 in the form of a loan from his former boss Dan Hirschberger. As security, Critser pledged some stock he owned. He agreed to repay the loan semiannually over a 3-year period at 10 percent interest.

The cash value of Critser's life insurance and his Series E Bonds brought $16,000 and $14,000 respectively. Another $10,000 came from his wife--savings she had accumulated working as a secretary. A $4,000 inheritance Critser had received several years before was to be retained for use as working capital, and this would be supplemented by the 10 percent fee he would receive from Rombaugh for collecting the accounts receivable outstanding at the time of purchase. This fee would amount to about $1,375 if all the accounts were collected.

How it all stacks up. With these arrangements, Critser's financial position with regard to the purchase of the business was as shown in the chart above. Almost everything he owned was either invested in or pledged to the business. One question remained: Would the business bring in enough cash to cover operating costs and other financial obligations?

The outcome--what will it be? Should he have bought the business? Can he meet his financial obligations? Will he be able to maintain enough working capital to replace inventory, pay his operating costs, and repay his debt capital with interest as the payments fall due?

Only time will tell how good a manager Critser is. Many businesses have been bought and operated successfully on a more precarious start than this. Perhaps he will prove capable of meeting the challenge. Perhaps not.

If he should fail what would he lose? Practically everything--his full investment of $40,000 plus whatever else is necessary beyond the sale value of the assets to satisfy his creditors. Whether he succeeds or fails will depend on how well he can administer the financial program of the store, how well he can merchandise, how well he can keep his costs in line, how near his sales come to his earlier estimates.