Requests for business acquisition financing are invariably met by a key question posed by prospective lenders. They want to know if the enterprise to be purchased will produce enough income for the new owner - the borrower - to be able to repay the loan. Of course there will be a need to provide collateral, probably assets of the business and perhaps other security offered by the borrower. But even if the lender will receive enough security interest in the buyer/borrower's personal or real property to cover the amount of the loan, it still will be necessary to demonstrate that the cash flow of the business will generate sufficient funds to meet the debt obligation.
And, as most buyers and all loan officers know, the profit and loss statements on the business that the seller provides, are unlikely to show all of the actual earnings the seller collected. Quite possibly, the buyer will collect enough money as owner of the business to meet the loan payments. Yet a look at the historical P&L's might not make that obvious. That's when it's necessary for the lender to understand the actual earnings expected by the proposed borrower, and it's up to the borrower to explain where the money will come from to support the monthly principal and interest payments.
As the prospective borrower points out cost items that don’t actually take any cash, as well as optional and one-time costs listed in the expense column, he wants to add the figures accompanying those entries to the bottom line; and then make the case that with these additions, there will be enough funds to pay off the loan as required. And while this is a very common and accepted practice, buyers can run into problems if not careful to include only legitimate addbacks in applications for business acquisition loans.
Depreciation Might Not Be A Legitimate Addback
The practice of treating depreciation as a non-cash expense is based on the assumption that the depreciable, or economic life of a capital asset is considerably shorter than its useful life. In other words, it's usually assumed that the $50,000 value of a manufacturing machine, for example, can be written off in three to five years, while it actually will be used on the production line for ten years or longer. And typically, the money theoretically set aside specifically for the purpose of replacing that machine will not be needed for several years. That’s why the depreciation figures assigned to that piece of equipment are considered non-cash costs that might appropriately be addbacks - funds available for other purposes, including the payments needed to get out of debt. This sum might not be a legitimate addback, however, if the equipment is nearly ready to be "retired," and the depreciation fund will actually be needed to replace it. In that case, the depreciation entry is not a "phantom" expense that can be added to the owner's actual earnings, but a real cost that will need to be paid.
When Personal Expenses Can't Be Used to Pay for Business Acquisition Loans
Also problematic is the attempt of a prospective borrower to convince a loan officer that certain expenses shown on the business P&L are actually for the seller's personal benefit and those amounts can be added back to earnings. That may be the case in some situations, but a loan applicant needs to be sure that the claim is accurate.
One common example is the cost of leasing, servicing, fueling and insuring the seller’s vehicle. If the vehicle is not needed for the business, it may be correct to argue that expenses associated with it can be added back to earnings. But the vehicle costs cannot and should not be added back if, for example, the new owner will need a car or truck to make deliveries.
Another personal expense that shouldn't be added back could be country club dues. Yes this looks like a non-business expense, unless the lender digs deeper and learns that the new owner will rely on the relationships cultivated at the club to sell the company’s products and services. Especially if that has been an important marketing strategy for the seller.
Help Available To Buyer/borrower In Recasting Earnings Statements
By correctly identifying seller expense entries, on business P&Ls, that can be added back to earnings and used for debt service, buyers often can strengthen their applications for business acquisition loans. But they can run into trouble if the addbacks aren't chosen correctly, or explained effectively.
That’s when it might be useful to seek the aid of a small business loan specialist with experience in helping buyers/borrowers prepare persuasive loan applications and get them reviewed by suitable lenders and financial institutions.
About The Author: For over 25 years Peter Siegel, MBA has provided niche business purchase financial advisory and loan brokerage services with SBA Loans, Non-SBA Loans, Retirement Plan Conversions, Hard Money, Bridge Financing, Note Restructures, etc. He assists with financing for: Business Purchases, Business With Real Estate Purchases, Franchise Resale Purchases, New Franchise Purchases, Pay Off Existing Seller Notes, Partner Buyouts, Employee Buyouts. Peter Siegel can be reached direct toll free at 866-270-6278 regarding getting professionally pre-qualified, advisory & loan placement services.
|Helpful Resources To Assist In Selling And Buying California Businesses|
|Willard Michlin, CPA, Certified Fraud Examiner, Due Diligence Services
Willard Michlin, CPA #106752, offers buyers step by step training & assistance in doing Due Diligence Services when they are thinking of making an offer, or are in process of investigating a business purchase. He helps to determine the actual net profit even when there is cash. Call 805-428-2063.
|Janet Carrera - Escrow & Bulk Sale Services - SF Bay Area
Redwood Escrow Services, Inc. is a full service, licensed independent escrow company. We are EAFC Fidelity bonded, fully insured & licensed with the Department of Corporations. Committed to offering our clients the most comprehensive variety of escrow services available. Phone Janet at 510-247-0741.
|Elizabeth McGovern: Escrow Services - SF Bay Area
McGovern Escrow Services, Inc., is a leading independent escrow company. We are a trusted partner with our clients, assisting them through the tangled bulk sale & liquor license transfer process. We provide attentive, quality & innovative customer service. Phone Elizabeth McGovern at 415-735-3645.
|Brad Steinberg, Broker - Laundromat Specialists
Laundry specialists - founded in 1968 by three laundry professionals, PWS is a family-owned corporation. Through the years it has grown to become the largest vended laundry equipment distributor in the United States. Call Brad Steinberg at 323-721-8832 to sell or buy a coin or card laundromat.
|Helen Yoo: Escrow & Bulk Sale Services - Southern California
New Century Escrow, Inc. is a fully licensed & bonded independent escrow company. Over 20 years combined experience in handling bulk escrow transactions. Multi-lingual staff that speaks your language, including Korean, Chinese, Vietnamese. Call Helen Yoo direct at 626-890-1151.
|Mark Chatow, Esq.: Legal Services For Buying, Selling Businesses
Mark has a broad range of small business purchase & sale experience from analyzing potential acquisition targets to successfully guiding buyers and sellers through the purchase & sale of small businesses. Mark can assist with contracts, negotiations, legal matters, etc. Reach Mark at 949-478-8393.
|Diane Boudreau-Tschetter: Escrow And Bulk Sale Services
California Business Escrow, Inc. is a full service independent escrow company serving all of California and has expertise in a wide range of escrows. Our team prides itself on providing an exceptional escrow experience. For more info phone Diane Boudreau-Tschetter at 888-383-3331 or 209-838-1100.
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