An agreement in which a prospective buyer, prior to learning the specific identity of a business, agrees not to disclose confidential information about the business, or the fact that the business is being marketed for sale, to any other persons, especially employees of the business, and its competitors. The prospective buyer also agrees not to attempt to circumvent the agency relationship between the broker and the business owner (Seller).
In business brokerage, “cooperation” generally refers to the willingness of the listing (Seller’s) agent to share the commission paid by the Seller with a selling (buyer’s) agent who brings a ready, willing and able Buyer. A listing agent who refuses to cooperate with buyers’ agents is one who intends to engage in “dual agency,” the act of representing both the Seller and the Buyer in the transaction.
In California, a broker can legally be the agent of both the Seller and the Buyer in a transaction, but only with the knowledge and consent of both the Seller and the Buyer. In a dual agency situation, the agent has a fiduciary duty to both the Seller and the Buyer, and must represent each party with the utmost care, integrity, honesty, and loyalty. For example, in representing both Seller and Buyer, the agent may not, without the express permission of the respective party, disclose to the other party that the Seller will accept a price less than the listing price or that the buyer will pay a price greater than the price offered.
Recast Financial Statement
Once a prospective buyer has been properly qualified, and has signed a Non-Disclosure Agreement, the Seller’s agent will provide a “Confidential Business Summary,” an in-depth report on the business prepared by the Seller’s agent, with the close cooperation of the business owner. An essential component of the report is the recast financial statement prepared by the Seller’s agent. Based on at least three years of tax returns or P&L statements, the recast statement “normalizes” the financial statements in order to show how the business would look with a new owner. One could also say that the purpose of the recast financial statement is to show the true operating profit of the business, and in fact, the “Seller’s Discretionary Cash Flow”–also called, “Seller’s Discretionary Earnings”–are the bottom line of most of these statements.
Most small business owners operate their business in a way that’s calculated to minimize taxes. They give themselves and family members as many perks and benefits as possible, put their children on the payroll, plow profits back into capital improvements, etc. These and other tactics are designed to keep profits (and your taxes) low, perhaps artificially so.
* removed your salary and perks, and those of family members you don’t expect to remain with the company
* removed any expenses or income that would not be expected to recur or continue after the sale (for example, income or expenses associated with discontinued products, or gains or losses from the sale of any business assets)
* removed any investment or other nonoperating expenses or income
* removed interest payments on any business loans, since you’ll be removing such liabilities from the balance sheet.
Seller’s Discretionary Cash Flow
This is the most common measure of profitability you will see in business-for-sale listings. Defined as the pre-tax earnings of the business before non-cash expenses, one owner’s compensation, interest expense or income, as well as one-time and non-business related income and expense items. If there are additional owners working in the business, their compensation needs to be adjusted to market rates.
Seller’s discretionary cash flow or SDCF is a common cash flow based measure of business earnings for owner-operator managed businesses. According to the International Business Brokers Association, SDCF can be determined as follows:
* Start with the business pretax earnings.
* Add non-operating expenses and subtract non-operating income.
* Add unusual or one-time expenses, subtract non-recurring income.
* Add depreciation and amortization expenses.
* Add interest expense, subtract interest income.
* Add a single owner’s total compensation.
* Adjust compensation of all other business owners to market value.
(Sometimes also called operational cash flow)
Earnings Before Interest, Taxes, Depreciation and Amortization. An approximate measure of a company’s operating cash flow based on data from the company’s income statement. Calculated by looking at earnings before the deduction of interest expenses, taxes, depreciation, and amortization. This earnings measure is of particular interest in cases where companies have large amounts of fixed assets which are subject to heavy depreciation charges (such as manufacturing companies) or in the case where a company has a large amount of acquired intangible assets on its books and is thus subject to large amortization charges (such as a company that has purchased a brand or a company that has recently made a large acquisition). Since the distortionary accounting and financing effects on company earnings do not factor into EBITDA, it is a good way of comparing companies within and across industries. This measure is also of interest to a company’s creditors, since EBITDA is essentially the income that a company has free for interest payments. In general, EBITDA is a useful measure only for large companies with significant assets, and/or for companies with a significant amount of debt financing. It is rarely a useful measure for evaluating a small company with no significant loans.
Financing provided by the Seller of a business, sometimes in combination with an SBA loan. Very few buyers pay all cash for a business, and the primary source of financing is the Seller. Moreover, the willingness of a Seller to carry a note inspires confidence in the Buyer, since the Seller continues to have “skin the game” for the term of the note. A Seller, however, cannot be expected to offer the same financing terms as a bank. Whereas an SBA loan is typically for 10 years, generally speaking, a Seller will not carry a note for more than five years. And while SBA loans are based on the Prime Rate plus anywhere from 1 to 2.5 points, a Seller may insist upon a higher rate of return. Conversely, a Seller may offer a Buyer more flexible terms than a bank, such as interest-only payments for the first year. A Seller may be willing to finance from 20 percent to a maximum of 75 percent of the purchase price of a business, depending on the strength of the Buyer and the availability of other types of financing. For example, if a business does not have good books and records, or lacks the consistent cash flow history required to pass muster with the SBA, the Seller may have no choice but to finance the bulk of the deal.
Many Seller’s will ask the Buyer to secure the note with a personal guarantee from the Buyer and his or her spouse. A personal guaranty is not a specific lien on any particular buyer asset, but is the guaranty that the buyer is placing all assets at risk as needed to satisfy the loan. If the seller note payments are not made, the seller has to proceed with the long process of formal foreclosure. But, to satisfy the foreclosure, the seller will have access to all buyer assets. The spouse’s signature is required to prevent the transfer of assets to the spouse’s name to dilute the buyer’s net worth.
If a business has three to five years of tax returns or audited P&L statements with consistent cash flow that’s sufficient to service debt and still produce a profit for a new owner, it stands a good chance of approval for business acquisition financing through the Small Business Administration’s 7(a) program.
The SBA itself does not make loans, but rather guarantees a portion of loans made and administered by local commercial lending institutions. Wells Fargo, Mechanics Bank and Comerica Bank are examples of local, participating SBA lenders.
7(a) loans are the most basic and most commonly used type of loans. They are also the most flexible, since financing can be guaranteed for a variety of general business purposes, including working capital, machinery and equipment, furniture and fixtures, land and building (including purchase, renovation and new construction), leasehold improvements, and debt refinancing (under special conditions). Loan maturity is up to 10 years for working capital and generally up to 25 years for fixed assets.
Participating lenders agree to structure loans according to SBA’s requirements, and apply and receive a guaranty from SBA on a portion of this loan. The SBA does not fully guarantee 7(a) loans—the lender and SBA share the risk that a borrower will not be able to repay the loan in full. The guaranty is against payment default; it does not cover imprudent decisions by the lender or misrepresentation by the borrower.
Some business-for-sale listings indicated that the business has been “pre-approved” for an SBA loan. What this really means is that the Seller’s agent has provided one or more SBA lenders with financial statements and other information, and the lender–specifically, an SBA loan analyst at the bank–upon completion of a cash flow analysis, has given his or her conditional approval, based on acquisition of the business by the “right Buyer.” Who’s the “right Buyer?” That’s someone with enough equity in real property to use as collateral for the loan, mitigating risk to the lender.
Most lenders will not spend the time to look “under the hood” of a business opportunity until they are presented with a copy of a signed Letter of Intent or Purchase Agreement between Buyer and Seller. Final approval from the bank generally will not come until the Buyer has begun his or her due diligence; hence, loan approval becomes one of the contingencies to the sale. It’s important to remember that a conditional approval may turn into a “no” when a broader group of experts at the bank meet in committee to further scrutinize the loan.