ValuAdder Business Valuation Blog

Business owners and buyers often conduct business valuation as part of a successful business sale or purchase. Yet there may be a difference between the economic value of a business and its actual selling price.

One key reason is that business valuation does not account for the terms of a business sale directly. You can choose a number of well-known methods to measure what a business is worth, under the standard Asset, Income and Market approaches.

But if you plan to buy or sell your business, you still need to address the issue of business affordability, given a specific set of business sale terms, known as the deal structure. A key question here is:

Given the business price and terms, does the business generate sufficient earnings to make its acquisition financially feasible for the buyer?

Business brokers often say that the terms of the business sale are more important than the selling price. Seller financing is one key differentiator – a deal that is at least 50% seller-financed can have a selling price that is over 20% higher than an all-cash business sale scenario.

In addition to seller financing, the major factors that affect the business affordability and, therefore, its selling price include:

  • Compensation requirements of the new ownership.
  • Required payback period on the business buyer’s down payment.
  • Capital expenditures expected in the near term.
  • Additional buyer funds needed for working capital.
  • Business acquisition transaction costs.

Business acquisition examples – deal terms matter!

As an illustration, consider these acquisition example scenarios:

Let’s say that you have determined that the business you want to buy is worth $750,000 and is expected to generate $250,000 in annual discretionary cash flow going forward.

You decide to make an offer reflecting this business value. You estimate that you will need to spend $15,000 to close this transaction. You expect the typical asset sale transaction, so you will need to provide additional $40,000 as the working capital.

The business seller is prepared to finance 20% of the purchase price over 3 years at 7.75% annual interest. A bank is prepared to fund 30% of the deal over 5 years at 8% interest. The bank also expects a debt service coverage ratio of 1.25 on all borrowed capital.

This means that you need to come up with the remaining 50% of the purchase price.

In addition to $60,000 annual compensation, you would like to see your down payment back in 4 years. You also estimate that the business will need new equipment in the next few years, an additional $15,000 in annual capital outlays.

Business purchase terms that do not work

Here is the summary of your business purchase scenario:

  • Offer price: $750,000
  • Closing costs: $15,000
  • Working capital: $40,000
  • Down payment: 50% of the deal.
  • Seller financing: 20% over 3 years at 7.75% interest
  • Bank financing: 30% over 5 years at 8% interest
  • Payback period on down payment: 4 years
  • Your annual compensation: $60,000
  • Annual capital investments: $15,000

You can use the Deal Check calculation in ValuAdder to verify if all the terms above make financial sense. This calculation shows the following:

Your annual debt service will be $119,080. To make the deal work, the business must generate annual discretionary cash flow of $325,475.

Clearly, this does not work because the business throws off a cash flow of only $250,000.

Business acquisition terms that make financial sense

Now let’s see what happens if the deal terms are changed as follows:

  • Offer price: $750,000
  • Closing costs: $10,000
  • Working capital: $40,000
  • Down payment: 20% of the deal.
  • Seller financing: 60% over 8 years at 6.0% interest
  • Bank financing: 20% over 10 years at 7.5% interest
  • Payback period on down payment: 5 years
  • Your annual compensation: $60,000
  • Annual capital investments: $15,000

How did you get there?

You were able to negotiate better seller financing terms, which reduced your initial cash outlay. The bank is also much happier with the generous seller financing and offers you better loan terms. Besides, you decided to do some of the due diligence work yourself, reducing the closing costs. You can wait an extra year to get your down payment money back.

Your new Deal Check calculation result looks more promising:

Your debt service is now $98,485 and the business annual discretionary cash flow requirement is just $230,107. This works fine given the $250,000 in available business cash flow.

Note that, without changing the purchase price, your new deal terms reduced the required annual business cash flow by $94,368! It also transformed a non-starter into a sound business acquisition offer.