In February I wrote about business sellers’ unrealistic expectations when it comes to what they think their business is worth. In the past I’ve written about how low interest rates and bank using the SBA guarantee program and its low down payment requirements plus a 10-year amortization have caused buyers to pay more for businesses than they would have years ago (because their payments are the same or less).
Now for the “gotcha.” As with just about everything, it’s about moderation. And this applies to any type of deal, not just the sale of a business, where terms influence the price.
Let’s say that the historical (benchmark) standard for the pricing of a business of a certain size and in a certain industry is four times pre-tax profit. But because interest rates are around 5%, down payments can be lower, and the buyer can amortize an SBA guaranteed loan over 10 years, he pays 5.3 times profit.
For a business with $1 million of net pre-tax income it means:
- Pre-tax profit – $1 million
- Price – $4 million
- Annual debt service – $725,000 (at 5%)
- Debt coverage ratio – 1.35:1 (above required minimums but way too low*)
- Pre-tax profit – $1 million
- Price – $5.3f million
- Annual debt service – $585,000
- Debt coverage ratio – 1.71:1 (a very healthy ratio)
So what the catch you ask? The seller got a higher price so she was more motivated to do a deal, the buyer has improved cash flow to grow the business and improve operations, and isn’t that what it’s all about.
First, the buyer will pay a lot more in interest, as there’s both a higher price and a longer term. Then, what if the business has some hiccups in the early years and with super-tight leverage the business stalls and all efforts are going to survival, not improvement?
Most importantly, what happens when the gold rush ends? What happens when interest rates are higher, the supply of businesses-for-sale increases, and pricing gets back to “normal?” (And believe me it will. It’s like a manager I had back in the 1980’s, when interest rates were 12% or higher, said to me, “Do you really think interest rates will ever get below 10% again?”)
Let’s go 5-10 years in the future.
- The buyer is a great operator and got a great business. She triples the business and now wants to exit. Ignoring the fact that larger businesses sell for more than smaller ones, all things being equal, she expects to sell the business for about $16 million. But pricing is back to historical norms and the market says she’ll sell it for $12 million. A very nice sum indeed but she’s wondering what went wrong.
- There was a hiccup in the early years and it’s stifled growth. The owner is burned out, maybe his health is failing, and the whole thing is just a drag. Profits have recovered and are now back to $1 million so he expects to sell for over $5 million, but can only get $4 million or so. Not wondering what went wrong, but really ticked off.
I started out talking about moderation. Paying a moderate amount over the benchmark price is fine (10%). But paying 30% more because the payments are manageable is ridiculous. Common sense should rule the day. Just because you can meet minimum ratios doesn’t mean you should. Just because you can over-leverage it doesn’t mean you should.
- This ratio is the amount of profit to annual debt service payments. In this case $135 of profit for every $100 of debt service. Many banks will go as low as 1.25:1 but experienced acquisition lenders want it to be at least 1.5:1.