At Tom Vignali CPA, Inc., we frequently have the opportunity to assist clients in the acquisition of assets or businesses. Recently, a business associate asked us to assist one of their clients in the acquisition of a business. The business was a stand-alone day-care facility grossing approximately 640K annually with an approximate cash flow (before owner compensation and taxes) of approximately 148K. The sellers owned the building and real estate, and were not selling these assets. The current rent expense was $6,400 per month, and the owners were willing to provide a 10-year lease for use of the building and real estate. The sales price for the business only was 385K. The potential buyers had approximately 42K as an equity investment into this transaction and were looking to fund the purchase package via bank financing.
Know what you’re getting into
Upon performing an initial due diligence to generate some realistic financial projections, we uncovered distressing information. Prior to applying for bank financing, the buyers had entered into a binding purchase agreement with the sellers for a purchase price of 385K. This occurred prior to our involvement. Subsequently, they did apply to a bank for a loan, and after a financial evaluation of the business was performed by the bank, it expressed an interest in lending 371K for the acquisition. This was significantly less than what the buyers thought they would receive in financing and would result in no available working capital from the loan proceeds. After legal, accounting, and loan guarantee fees were paid, it was evident that approximately 20K would be needed from the equity investment just to cover the initial purchase, leaving the buyers with only 22K in available working capital. Since the buyers had pre-agreed to a purchase price prior to obtaining a business evaluation or bank financing, there was no ability (or willingness on the seller’s part) to re-negotiate the sales price.
Additionally, we were able to obtain the proposed 10-year lease for the real estate and discovered that the rent would be increased from $6,400 per month to $7,376 per month for the first two years (this was a $976.00 per month increase, or an annual increased expense of $11,712). In the tenth year, the rent would be $8,492.10 per month ($101,905.24 annually).
The loan payment would be approximately $4,500 per month (54K annually), and the owner expected to draw $3,440 per month (+ taxes of $1,000 per month). With a payroll that averaged around 25K per month (low: 22K / high: 34K) in addition to the increased rent, loan payment, and other expenses, an optimistic projection of available working capital would be approximately 13K per month. This was in sharp contrast to the buyer’s initial expectation that they would have at least 42K of available working capital. The venture would start out seriously undercapitalized, and at the end of the lease, the buyer will have paid off the seller’s mortgage but have no assets to show for it.
Takeaways for buyers
So, we have the following observations:
- Obtain business evaluations and appraisals prior to negotiating a purchase price
- Obtain a letter of intent from your potential lender identifying terms and loan amount
- Do all of your due diligence prior to entering into a binding purchase agreement
- Obtain lease terms and amounts (if applicable)
- Perform accurate and realistic financial projections
- Provide for adequate working capital (two months’ expenses at a bare minimum)
This scenario is not all-inclusive of what needs to be done when purchasing a business. It is just a snapshot of one example we came across. There is an extensive list of issues that need to be addressed when performing business acquisition due diligence.
If you would like to further discuss this issue or any other accounting issues, don’t hesitate to contact us at: Tom Vignali CPA, Inc.
Contact Us:
Thomas W. Vignali CPA Inc.
118 Point Judith Road
Narragansett, RI 02882
T: (401) 415-0798
tom@tomvignalicpa.com
www.tomvignalicpa.com
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