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- Lesson #4
Welcome to lesson #4 of “Learn How To Buy A Cash-Flowing Business In 5 Days.”
If you missed lesson #3 or want to refer back to it, click here.
In today’s lesson, we'll cover how to structure a deal.
There are a few key considerations when structuring a small business acquisition, so I’ll make sure to break down the most important ones that go into an LOI and Purchase Agreement for you in plain English.
Let’s get started!
The first thing you need to consider when structuring a deal is valuation.
Here are the 3 steps you should take to determine how much a business is worth:
Step 1: Understand the business’s assets and liabilities, its market position, and model out its future earnings potential.
Step 2: Look at comparable recent transactions of a similar size in the industry and what EBITDA multiples they traded at. I recommend checking out Bizbuysell’s report and speaking with other business buyers who have ears on the ground.
Step 3: Understand what you can afford. If you’re taking out an SBA loan, banks have a certain debt service coverage ratio (DSCR) requirement. DSCR is one of the most important factors lenders look at when approving a loan. It’s calculated by dividing a business’s net operating income by its total debt service. Most lenders want to see a DSCR of 1.5x or more. Bookmark my quick deal analysis calculator »
Remember, the asking price that a business is listed for is just a conversation starter.
Next, you need to decide how and when you’re going to pay for the purchase.
As a buyer, you likely want to pay the lowest amount of cash upfront as possible and leverage the cash flows from the business to fund later payments. You also want to withhold some payment so you mitigate risks associated with the business as much as possible.
There are two main ways to structure how future payments are paid: seller notes and earnouts.
First, let’s talk about the seller note.
The two main points you have to negotiate here are the length of the note (commonly 3-7 years) and the interest rate (commonly 6-10%).
You can also negotiate interest-only payments for an initial period (i.e. 1-2 years) followed by balloon payments, which are large, lump-sum payments scheduled at the end of a series of smaller periodic payments.
As we spoke about in the previous lesson, a seller note is a great way to reduce your equity contribution to a business as the buyer.
However, as importantly, it’s a great way to tie the seller to the transition and future of the business beyond just the seller’s word. You can tie a seller note to a seller working through the transition period, business performance, and more.
The seller note can also be used to protect the buyer from material misrepresentations, or even key risks such as customer retention or customer concentration through clawback provisions that allow the buyer to take back money that has already been distributed. Banks also like seller notes because it shows the seller is confident in the new owner’s abilities and leadership.
Ultimately, when a seller is willing to offer a seller note, it’s a good sign of faith that they believe in the future of the business.
Next, let’s talk about earnouts.
First, it’s important to note that you can’t use earnouts with an SBA 7(a) loan (however, you can accomplish similar goals with a seller note).
Earnouts are contingent payment(s) tied to performance that makes for a great way to bridge valuation gaps between the buyer and seller.
Earnouts are generally 1-5 years and can be tied to revenue and EBITDA targets.
It can be structured as one large balloon payment or multiple payments during the earnout period.
Ultimately, I always recommend leveraging a seller note or earnout. In fact, I wouldn’t do a deal where the seller requires 100% of the payment upfront.
A few other important considerations when structuring an acquisition are:
Transition plan and employment/consulting agreements
In my opinion, one of the riskiest parts of buying a business is the transition period. You want to make sure the seller will be around to show you the ropes so that you can learn exactly how to run it.
Usually, a seller will include a certain amount of time working in the business as usual for free. Sometimes, you may need to pay the seller for his/her time, whether that’s full time or part time.
In general, I like to have the seller be around for 6 months to a year.
Non-compete agreements
Make sure the seller signs a non-compete (5 years is most common). You don’t want him/her to start the same business next door and take all your customers.
Assets, inventory, real estate, working capital peg
You want to agree to what assets come with the business you’re buying, how much inventory comes with the sale, whether real estate is included or can be rented from owner, as well as how much working capital will be in the business at close.
Asset vs. stock purchases
I pretty much recommend asset purchases 99% of the time. In an asset acquisition, the buyer is able to specify the liabilities it is willing to assume, while leaving other liabilities behind. In a stock purchase, on the other hand, the buyer purchases stock in a company that may have unknown or uncertain liabilities.
The only situation where you may want to consider an stock sale is if the company has certain nonassignable contracts, permits, and licenses or if these contracts, permits, and licenses would be in severe jeopardy in the event of a reassignment.
This is just an overview of the key considerations when structuring a deal.
There are nuances to every transaction, so I always recommend hiring legal counsel with experience with M&A transactions when structuring your deal.
When the time is right, I’d be happy to make a personal introduction to legal counsel I trust.
Well done! You’ve made it through lesson #4.
Keep an eye on your inbox tomorrow for the final lesson, lesson #5. (or click here to dive right into it).
We'll wrap up by walking through how to conduct due diligence. We'll also share what vendors you'll need on your side to help you close a deal.
See you tomorrow!
P.S. Want me to help you find a business to buy in the next 90 days and handhold you through closing your first deal? Book a call.
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