Ask nearly any business owner, “What’s your business’ most valuable asset?” and most likely you’ll hear, “my customer base”. (Every once in a while you may hear, my employees.)
Microsoft obviously agrees with that as they recently injected $240 million into Facebook in exchange for a very minor stake in the business (~5%). That projects a value for Facebook of around $15 billion dollars with between $150-200 million in revenue in 2007. You heard that right, Microsoft values Facebook at around 100 times revenue! Why? – Because they have a loyal customer base of over 65 million users with 250,000 more added everyday and over 50% of whom log into their Facebook account every day. Granted, this $15 billion dollar company does everything out of a few offices in California and New York. They have very few tangible assets.
Since few of us are looking to buy, build, or sell a Facebook style business any time soon, what does this have to do with those of us involved in small business?
Well if you’ve ever tried to get a business loan from a standard bank, contrary to the “real world”, you learn quickly that they don’t consider “customer base” an asset at all. As a matter of fact, it’s not worth anything. A bank looks at 2 things:
- EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) multiplied by some arbitrary multiplier OR Indirect Cashflow (both are poor measurements for available cash if your business is based on accrual accounting, but we’ll address that in another blog).
- Liquidated Assets – If they sold everything your business owns EXCEPT for the customer list, what’s that worth?
If one of those 2 things isn’t up to par, no loan. That means if your business has revenue of $1 million and EBITDA times their arbitrary multiplier (generally 3 to 5) is $500,000 and your building and other tangible assets are worth $150,000, the bank will only loan you about $120,000 (80% of the “assets”). After all, they’re not in the business of selling businesses so they HAVE to do it that way.
Let’s consider a bit of irony in the system. If you have ever learned about how banks handle foreclosures you’ll understand that most banks have a department called Real Estate Owned (REO) to help resell properties that they have foreclosed on. In theory, they are trying to resell these homes as soon as possible because as all banks will tell you “we’re not in the real estate business.” In essence all REO properties in their portfolio are liabilities because of that. That seems to make sense. They’re in the money business not the real estate business so if they don’t have a mortgage against the property they’re not making any money.
So then why, when they look at my business (or any other business), do they insist that I am in the real estate business? After all the only “asset” they claim I have are my buildings and tangible property. What kind of business owner with a healthy, well-established business, would break it into pieces to sell it asset by asset? None (unless they somehow alienated their customer base).
That’s literally the same thing as if the REO departments of banks sold foreclosed homes piece by piece. First they send someone over to value the doors, windows, and carpet. Then they get a value on the cabinetry, kitchen items, toilets, sinks, bathtubs, etc. And then piece by piece, sell it off. After all, they’re not in the real estate business so how could they possibly try to sell real estate?
Business works the same way, it makes absolutely no sense to value a business as a sum of its tangible assets because no business is in the asset gaining business. Just like banks will often enlist the help of real estate brokers, business brokers can also be utilized. Heck, as a requirement to secure the loan you could ask the business to indicate 3 ways, places, or people who they would sell the business to if they had to.
Now here’s the worst part of all of this. A banker has recently told me they are tightening up their criteria for commercial loans because of the sub-prime loan fiasco.
Come again? You’re punishing commercial loan seekers because you didn’t have the foresight to realize sub-prime loans were a bad idea?
If you’re not familiar with sub-prime loans, here’s a quick review. You want to buy a $200,000 home and can’t afford the $1200 a month payment at the current interest rate. So the bank says, no problem. Just pay $900/month for the next 3-5 years (the time frame is set forth up front). By then you’ll have been promoted, got a better job, won the lottery, etc. and can afford a $1200 payment for a few years and then eventually you’ll have no problems with a $1500 payment waaaaay down the road when you’ll obviously be making tons more money than you are now because that’s what happens in everyone’s life. Now the bankers get together and think
A. we’re going to make a killing on all of these new loans and all of the interest from them AND
B. worst case scenario 3-5 years down the road the properties will have gone up in value and have plenty of equity in case this person can’t make the payment and we foreclose.
That appears to meet the 2 heralded criteria every banker reviews for a loan mentioned above. Does the person have the cashflow (uh, well, sorta… I mean, I’m sure they eventually will…)? Is the loan secured by a tangible asset that we can sell if necessary? As it turned out, not everyone got that extra promotion to afford the higher payment. To make matters worse, real estate values in most of the country actually went down. So why does this annoy me? Because I thought banks weren’t in the real estate business… If that was the case, why were they “investing” in the real estate appreciation? The ONLY way the sub-prime loans could have worked based on the 2 criteria that banks developed for themselves, was if real estate steadily went up in value. So, yes, the banks got themselves into the real estate business in a big way.
So now, a business I’d like to buy with a bank loan has a nice net profit margin (enough to easily pay back the loan), has been around for 40 years, has had substantial growth for at least the past 3 years, and continually grows its most important and valuable asset (i.e. it gets new, loyal customers on a daily basis) and yet the banks can’t see past the “tangible assets” of the business to secure a loan… Partially because they thought it was a good idea to give money to people who couldn’t afford to pay it back…
Now what? Do I give up? Of course not. I’m not one to present a problem with no solution because where there’s a will there’s a way. This snag, like most any other business challenges, can be overcome.
Here are 3 potential ways to still buy a business without a standard bank loan:
- The majority of business purchases are vendor financed so that may be an option.
- Friends and family can always be an option (either to loan you the money or to loan you their signature to get the financing you need).
- As nearly every software and internet company in the Silicon Valley has found out, Venture Capitalists are alive and well.
If you’re in the process of securing a commercial loan, hopefully this blog gives you a few negotiating points you may want to use with your banker. Otherwise, you can’t get too worked up about things you can’t change – no matter how ridiculous they are. If you’re in the business buying mode, start with a business that would require a smaller loan. Or keep looking for one where the owner is willing to finance it for you.
To your success, Bryan