Analyze the Deal Like a Bank
3 Questions to Ask Before You Call Your Lender
You’re evaluating a business. Are you the buyer or the seller? It doesn’t even matter. Unless there is a giant pile of cash going into this deal, a bank is going to be involved…you hope. But the bank has to be convinced it’s a good investment, a good risk for the bank. Otherwise, how will this deal get done?
If you’re the buyer and you think this is the perfect business for you, if you’re the seller and you really need a big exit, you have to run the numbers, and use logic to analyze the deal. This is not a complete analysis, but begin by asking yourself the following three questions:
1. Is the free cash flow from this business enough to support the payment required to buy the business? This will always be THE priority. The bank will not loan money unless they are very confident of getting it back in a timely fashion.
Business acquisition loans are amortized, or spread out, over relatively short time periods. You won’t be seeing 30 years like you do for a home purchase. Five to seven years is more likely. And the interest rates are often higher as well.
The bank will also want some wiggle room. An annual profit of $100,000 does not mean the bank will allow you to have a loan with $100,000 of annual payments. They will want a margin of safety built in, the wiggle room, or if you want to get fancy, a debt-service coverage ratio (DSCR) greater than 1. It will vary from lender to lender and the individual circumstances, but the bank is likely to require a debt-service coverage ratio of 1.15 to 1.5.
I like to use tiny numbers to illustrate a new concept. If the loan requires monthly payments of $100, that’s $1200 per year. A 1.5 debt-service coverage ratio means they want to see profit of at least 1.5 times $1200. In other words, the bank will require at least $1800 a year of available profit to make those loan payments. And that’s just the beginning!
2. Is the free cash flow enough to ALSO cover a downturn in the business? As mentioned above, there must be built in wiggle room, both for the bank and for your own piece of mind.
Expenses need to be covered and loan payments must be made before anything hits the owner’s pocket. If you’ve ever struggled to pay your bills like I have, you know it’s absolutely no fun! Add to that the pressure of having employees rely on you for their livelihood? That can be a whole new level of heart palpitations. As entrepreneurs, we’re often an optimistic lot, but positive thinking doesn’t pay the bills. Use this as an opportunity to set yourself up for success.
3. Is the remaining cash flow enough to provide the necessary income for the buyer? Unless you have another steady source of income, or you’re independently wealthy, the target company is probably meant to provide an income for your family. No one wants to live wondering how rent is going to be paid and how much longer until the utilities are shut off, and you shouldn’t have to. That’s part of the brilliance of buying a business instead of starting from scratch; you can buy exactly the “income” you need and want to support yourself or even enhance your current lifestyle. Think bigger!
Let’s look at an example together. Say the average annual profit is $100,000. There are a handful of employees, a couple of company vans and lots of small tools and supplies on hand. As a seller, you started this baby from scratch and you’re running yourself ragged trying to keep up with all your customers. Surely, your business is worth, oh… half a million dollars, right?
Here is the bank’s/buyer’s perspective. (We haven’t even touched the topic of a down payment so we’ll ignore that for now.) A $500,000 business acquisition loan will be spread over 7 years. Interest rates are rising at this writing, but 6.5% is a good place to start. Using any loan amortization spreadsheet or app, you will see the monthly payments come out to $7,424. Call it $7,500 a month or $90,000 a year. The profit more than covers that, a good start!
Free Cash Flow (Profit) 100,000
Winging It Valuation 500,000
Loan (500,000 over 7 years @ 6.5%) 90,000
Excess Cash After Loan Payment 10,000
But the bank wants a debt-service coverage of 1.5. That’s $90,000 times 1.5 which is $135,000 of profit required by the bank in order to give this loan. Now we’re in a bit of trouble. At least $35,000 of trouble, every year. Can we generate an extra 35 grand? We have big plans for this business…?
Free Cash Flow (Profit) 100,000
Debt Coverage of 1.5 (x90,000) 135,000
Excess Cash Flow After DSCR of 1.5 -35,000
What if the business drops? What if a few things fall through the cracks while transitioning to the new owner? What if the economy shifts a bit in the first couple of years? What if business declines by just 5%? That would bring the profit down to $95,000.
Free Cash Flow in a Decline (Profit) 95,000
Debt Coverage of 1.5 (x90,000) 135,000
Excess Cash Flow After DSCR of 1.5 -40,000
Yikes! And the buyer hasn’t even been paid for their efforts or for their investment. Proceed with extreme caution!
Now we’ll go back to a more reasonable sales price, which is a whole new conversation, but $253,000 would be about right. (According to the latest quarterly Insight Report by bizbuysell.com, the average small business is selling for a multiple of 2.53.)
$253,000 amortized at 6.5% over 7 years results in monthly payments of $3,712 or round it to $45,000 a year; much more manageable!
Free Cash Flow (Profit) 100,000
Reasonable Valuation 253,000
Loan (253,000 over 7 years @ 6.5%) 45,000
Excess Cash After Loan Payment 55,000
Now take the $45K times a 1.5 debt service coverage and you get $67,500. Still manageable, even with a 5% decrease in profits as shown below.
Free Cash Flow in a Decline (Profit) 95,000
Debt Coverage of 1.5 (x45,000) 67,500
Excess Cash After Loan Payment 27,500
This deal seems to be on the right track, but there is still an issue. Even with a reasonable sales price, there isn’t much left for the new owner’s income, only $27,500. Can you live on $27K a year? Can anyone? Can you convince the bank that that amount is sufficient to meet your needs? That’s going to be a tough sell, but don’t give up yet. This is a great time to learn about seller financing…
