Selling Real Estate – Income Mixology

Proper exit planning requires inputs from many experts. Besides exit planners, CPAs, consultants.and intermediaries, SBA lenders can be a great resource in understanding how to best prepare for an eventual exit. Even if the business buyer does not need a loan, many buyers are trained financially and may act similarly to SBA lenders. Any seller whose business can be sold with an SBA loan will have more options and a larger pool of buyers to help boost their exit value. In this article, we describe some golden nuggets from a seasoned lender. There are no specific recommendations since each business is different. The pros and cons of certain actions depend on the business characteristicsa financial analysis of the action, andtiming of an exit Owners should seek the advice of qualified professionals. It is even more important to seek that advice early. Most of the meaningful value enhancing strategies require years to plan and execute. Arguably, every business owner should engage in value growth and exit planning strategies as soon as six months after starting or acquiring a business. Knowinng the exit options at all times is critical to running any business. Perks Can Detract from the Exit Value of the Business While business perks generally benefit the owner, they can create issues that suppress the business value when it comes time to sell. For example, if a business owner runs personal expenses through the business credit card, it may be challenging for them to claim these as personal expenses to a buyer or a lender. In one case, the owner had $50,000 of personal purchases on the company credit card. Let’s say this saves the owner $20,000 in taxes. If they had kept those purchases off the business credit card, the business would be $50,000 more profitable. If the business trades at a 3 multiple, the owner has made their business $150,000 more valuable in a sale. Rather than benefit from a short term $20,000 tax dodge, they can put $150,000 more in their pocket when they sell the business. Even after taxes on the gain from a sale, they will come out ahead. In another case, a large manufacturer benefitted from $50,000 of scrap metal revenue that was paid in cash and left off the books. The same numbers in the above example apply in this case. Many retail businesses have unreported cash which causes owners to leave money on the table when they sell. Owners should clean up items like these well in advance to maximize their exit. Utilities Can Be Opportunities to Add Value to the Business Utilities can be significant for many businesses, especially businesses that require significant gas and electricity to run equipment or cool working environments such as factories with furnaces. One business owner found two ways to save large sums on their utility bills. They found an alternative carrier for their gas supply and they also found an electric company incentive that offered a lower rate for making a capital investment in the building’s electric infrastructure. Each program saved this manufacturer approximately $100,000 annually! The electric program required a $50,000 investment. This investment is a no brainer with a 6 month payback. And for an owner preparing to sell the business, these huge utility savings multiplied by a 3 multiple make them a windfall. The capital expenditure would not detract from profitability or lendability as it could be shown to be a 1-time investment. NOTE: The lender’s view on unusual items like these massive utility savings could depend on the lender. The SBA lender I spoke with and her boss felt that at least partial credit could be given to a new utility contract with significant savings (partial because of the possibility of rates rising after the contract) and significantly more credit could be given for a “permanent” rate reduction in exchange for infrastructure investment. Naturally, the owner would need to provide contracts, documentation and proof of lower bills. Seller Financing with an SBA Loan SBA lenders often do not require seller financing on small transactions that may be in the hundreds of thousands of dollars. On transactions in the millions of dollars, SBA lenders may require the seller to finance 10-25% of the deal. Lenders like it when the seller has skin in the game to ensure a smooth transition. On the other hand, lenders do not like sellers to retain ownership as they prefer their borrower to be the sole decision maker. Seller financing can be done with a full standby or partial standby. Full standby means that payments on the seller note are not made until the borrower pays the SBA loan back in full. Partial standby means that payments on the seller note are not made until after a specified period of time. While these options may not sound attractive to a seller, there are considerable advantages to the seller. Taxes on the sale are deferred over time for the portion that is financed by the sellerThe bank may not need to include buyer payments to the seller when calculating debt service coverage, even if the seller standby is as short as 2 years. This means the buyer can qualify for a little larger loan, which may mean they are able to offer a little higher price to the seller. CAPEX Affect on Loan Amount For planning purposes, sellers should know that lenders will look at the historical capital equipment requirements of the business. If lenders see a significant and consistent capital equipment expenditure in each of the past five years, they may feel this is an ongoing requirement. In reality, it may be what the owner is doing to shore up the business and avoid capital expenditures for the next ten years. Inventory Affect on Loan Amount Inventory may be purchased at closing subject to a predetermined value, such as at cost. Alternatively, the buyer may assume the inventory on consignment at closing and pay the seller an agreed-upon percentage of each future sale until the inventory value is paid off or until a certain timeframe such as one year. This is another form of seller financing which enables the SBA loan amount to be larger, thus enabling the seller to get more at closing. Working Capital Treatment in the Sale of a Business Sellers typically do not realize that working capital can be a major snag when selling their business. If a business requires a significant amount of working capital, a buyer will often want that working capital to stay in the business as part of the offer. This can blow up a deal when the seller discovers this during the offer process. This revelation catches them off guard and the seller gets a sour taste in their mouth from something that feels like a bait and switch, and in their mind defies logic. After all, they worked hard for that money. A manufacturing business I listed for $3M had $800K in working capital requirements. When each side thinks they are getting that $800K, the deal is too far apart. If a buyer comes in with an SBA loan, they may be able to get a line of credit for working capital. This can help somewhat, but the payments on the line of credit , plus the payment for the SBA loan, plus a payment on a Seller note all add up. Sellers who have large accounts receivables should work to reduce that amount as much as they can. Buyers and lenders often look back 18 months to see working capital requirements. Many owners feel they are stuck with the terms and payment patterns of their precious customers. However, sellers can incentivize customers to pay early. One owner had a NET 30 customer that always paid in 10 days in order to capture a 1% discount. The buyer would never change the terms since they loved the discount. They did an analysis on all the money they could save if they could pay early to all their suppliers for a 1% discount. Every business is different, and some value cash flow more while others value savings more. Rent Effect on Loan Amount If a business owner also owns the real estate, there are several considerations on how to optimize the sale of the business. If the buyer is also purchasing the real estate and the mortgage is less than the seller’s current rent expense (the rent the owner charges themselves), this helps the buyer get a bigger loan on the business.While SBA loans are typically 10 years, a loan package that includes real estate can be amortized over 25 years for both the business and real estate.If the owner’s rent payments to himself are below market rent, the owner could offer the same low rent to the buyer and a three year option to buy the real estate. This locks in the low rent which is better for profitability and will net the seller more on the sale. A lender does not care about market rent - they only care about the rent amount that a buyer must pay. A three year option is important since most banks will enable a buyer to purchase the real estate after two years. Operate the Business as if You are Keeping it Owners should consider operating for the long term even as they gear up for an exit, perhaps aside from major capital equipment expenditures or other significant strategic initiatives. This kind of “growth-minded business as usual” vision and execution will ultimately help the Buyer decide to acquire the business. Other Golden Nuggets from a Trusted Lender Here are more general lending insights that are important for buyers and sellers to understand. The lender looks at owners’ salaries, whether one or several owners, and determines whether compensation is at market rate. They also look at the roles of the owners. If two semi-absentee owners draw full salaries but they can be replaced by one full-time owner-operator, then the lender will allow an add-back for one of the owner’s full salaries. On the other hand, an owner who works at a reasonable salary but puts in 80 hours per week may need two people to replace him. If those two people will result in 1.5 times the owner’s salary, then there is going to be a 0.5 x salary negative add-back.The lender also looks at the buyer’s salary requirements. If the buyer already owns a business that pays a comfortable salary, they may not need to draw a salary from the business they are acquiring. This means they can borrow more. On the flip side, if a buyer is transitioning from a $250,000 salary job and is willing to take a $100,000 salary as a business owner, the lender has to assess the buyer’s ability to maintain their current lifestyle on such a reduced salary. Maybe they have high mortgage, auto and credit card payments, little savings, and no other income. In this case, the lender needs to put a higher salary in for this buyer, which is going to reduce the amount of profit available to run the business and make loan payments. The lender will have to lower the loan amount to meet the debt-service coverage ratio.Banks lean on tax returns to do their cash flow analysis, but take P&Ls for the most recent period when the tax return is not yet available. The cash flow analysis for the most recent year based on a P&L will have differences compared to the prior years based on tax returns. For example, distributions to officers may appear in a P&L. This might get lumped in with the owner's salary and make the owner's salary look quite large in the most recent year compared to prior years. The prior years are based on tax returns, which do not show owner’s distributions.Add-backs in the most recent year may be carried back to previous years even though they did not exist. For example, if there is a rent add back in the most recent year because the owner paid themselves above market rent for some reason, this add-back will also appear in prior years where the owner paid market rent. The reason is that the cash flow analysis is looking at debt service coverage over a 3-5 year period making it reasonable to carry add-backs to prior years even though they were not add-backs in real life.The SBA has guidelines on debt service coverage ratio, and then banks overlay their own criteria which may vary by bank. The SBA’s minimum guideline is to hit the debt-service coverage ratio in the most recent year, but then a bank like Live Oak Bank might require hitting the ratio at least two of the last three years. Banks can also make exceptions such as two out of the last five years if COVID or some other anomaly was involved.Timing of the tax return is important. If a business is selling at a time when the next tax return will be available in a couple months or less, that tax return may be required by the SBA lender during escrow. Any lending analysis using a P&L for the most recent year will be replaced by the most recent tax return. This can change the lending scenario in cases where the tax return differs significantly from the P&L. P&Ls used for lender or buyer evaluations or due diligence should be blessed by the CPA after year-end adjustments are made. Some businesses have very little year-end adjustments while others have large adjustments, which can change the complexion of a transaction, the loan, and the value of the business.