Be an Ethical Entrepreneur, Marketer, and Business Builder

Your business DOES need an exit strategy!

In the last few days I read an article on Entrepreneur.com and the book Rework where people have said buying or starting a business with the idea of selling it is horrible. They gave various reasons why this disgraceful practice will hurt your business including it leads to a lot of bad things, you won’t focus on customers, and you will be too distracted by cashing out to do a good job.

Respectfully, I disagree with Jason Fried, David Heinenmeier Hansson, and Michael Mothners. Firstly, it seems obvious that all of them have only been involved in growing or starting their own businesses so I’d suggest their experiences in different types of businesses with different owners is a bit limited. For instance, Fried and Hansson suggest that business owners looking to sell are generally trying to get acquired. Huh? In the 100 plus business owners I’ve worked with I don’t recall ever hearing about someone wanting to get acquired. That’s just a bit of the authors projecting their experience as a software company and of the software industry overall to all businesses and it just isn’t that way for businesses outside the technology realm. Mothners also owns a technology company so I’m guessing his disdain for exit strategies is based on the idea of companies popping up just to get bought out by Microsoft or Google.

In the real world of brick-and-mortar businesses few owners have that vision. As a matter of fact, most owners have no idea when they should sell their business, how to sell it, or even what it’s worth. What’s worse is few appreciate that if they’re working IN the business everyday instead of ON it their business is worth significantly less once they stop working there. My point is that why make a statement such as, “building a business to sell it is a bad idea” when the negative situations that they are concerned with are probably less than 1/10th of 1% of the total transactions and businesses? There are nearly 250,000 businesses sold in the US each year and that only represents about 20% of the total businesses listed. In other words, only 1 in 5 businesses grossing under $10 million/year will sell. It doesn’t sound to me like building to sell is the problem or you think more people would be able to actually find a buyer.

So what are the real problems small business owners face?

  1. They don’t know how to build a business. In Built to Last: Successful Habits of Visionary Companies, Jim Collins discovered that businesses that remain profitable for decades (even centuries) remain that way because they are great BUSINESSES not because they have great products. Most business owners focus on delivering a certain product or service without figuring out how to build a great business.
  2. They don’t know how to distance themselves from the business. In other words, they make the business completely dependent on themselves. If they’re not there working, selling, servicing or whatever, the business isn’t running. That means when they go to sell the business it’ll be worth a whole lot less without them there. Not only that, the only people interested in buying it will be buyers who also want to work in the business not investors. Working buyers generally don’t have as much cash as an investor looking for a steady return on his money.
  3. They don’t know what their business is worth or how to increase its value. The result of that is they always want more money for it than anyone else is willing to pay.

So what’s the solution to fix all of these real problems that I would estimate nearly 80% of business owners have? An exit strategy, of course. Here’s why an exit strategy is so important:

  1. It forces the owner to look at how to make the business great. Few people (myself excluded) want to buy a business that isn’t run well. They generally want a business with a strong, steady history of cashflow with minimal headaches and issues. If your primary focus is simply to grow and work in your business it’s very hard to step back and look at the big picture of your business being a finished product that runs so smoothly someone else would love to own it.
  2. Owners will need to figure out how to remove themselves from the business. You can’t sell the business if you’re required to run it, so an exit strategy will help you focus on working ON the business more than IN it.
  3. They will have to come up with a reasonable value for their business. Most business owners have an idea of how much they’d like to get for their business when they sell it. Unfortunately, that number doesn’t usually correlate with what it’s actually worth. With an exit strategy you need to look at a reasonable value for your business today and then set a game plan for increasing it’s value to the point where you can sell it for what you want. No exit strategy and chances are you’ll never really look at it’s value. This is very sad because most business owners only sell when they’re ready to retire. In essence, their business is their retirement plan. So if they go to sell and find out their business is only worth half of what they thought, that makes for either a tough retirement or a lot more years of work.
  4. It forces a time table for the 3 items above. Without an exit strategy with a specific time frame, few owners will ever do the things above even if they know they should. “There’s always tomorrow, or next month or next year to get that done… I have customers to take care of today.”
  5. Buying, building and selling businesses is generally a much faster system for creating wealth than buying, building and keeping. I’ve explained this in previous blogs so I won’t address it again here. This philosophy is probably what is thought of as a “bad idea” however, in my experience, this generally greatly benefits the businesses being acquired and resold. Why? Because people who are doing this understand how to make a business better. Not just a shell game of cleaning up the books, but a business that takes care of its customers, employees, vendors and owners better. Truly an improved business comes out the other end when an experienced person takes over to increase the value of a business to sell. I’ve written a 5-part series of blogs outlining how someone can go about buying a business and quickly improving it.

In summary, be wary of advice from business experts who have only owned or run 1 business or in a single industry and then attempt to extrapolate their experiences and lessons to all businesses in all industries. The real world, where over 5 million businesses exist in the US, is quite a vast landscape. More importantly, if you’re ever looking to retire or sell your business, you need to work on an exit strategy immediately. Make it a priority to get done this week! Contact me if you have any questions on how to structure a reasonable plan.

To your successful exit strategy, Bryan

Business Valuation – Public, Private, and Internet Businesses

As I’m reading Adam Penenberg’s book Viral Loop: From Facebook to Twitter, How Today’s Smartest Businesses Grow Themselves, 2 main themes have caught my attention. Firstly, the power and consistency of creating a viral loop for your business. Secondly, though the item I’m blogging about first, is how differently businesses can be valued.

I’ve written regularly about valuing small businesses based on the mantra “it’s all about profits”, and yet have learned of dozen’s of businesses worth hundreds of millions to billions of dollars with little to no profits to back that up. Penenberg references HotorNot, Hotmail, Paypal, Ebay, Bebo (even though they didn’t use their venture capital money), Myspace, Facebook, BirthdayAlarm, Netscape, Ning, Twitter and others that almost universally had substantial losses each month when venture capitalists started investing millions or 10’s of millions of dollars into these businesses. A good friend of mine, and MBA student, had argued with me many times that business is all about getting customers. I always countered that you can have a million customers but if you lose $1/month on each one, that’s not a good business. It seems, however, that both of us weren’t looking at the entire scope of business.

So when we value businesses, there are basically 3 primary groupings to consider:

  1. Small, closely-held businesses (which is what I most often write about)
  2. Internet Businesses
  3. Public Companies

In small, closely-held businesses, I am right. It’s all about profits and your business should be valued on that. If you’re buying one of theses businesses and it has a loss, you may just want to offer to take it off of the seller’s hands for them so they don’t continue to incur the losses. These are your every day “main-street” (pardon the cliche’) businesses that you find for sale on Bizbuysell.com and other websites. Theses businesses are generally your first step toward wealth creation.

Internet Businesses open up an entirely other ball of wax. These businesses rarely have any income and certainly no profits early on in their life-cycle, however manage to attract anywhere from hundreds of thousands to hundreds of millions of dollars in investment capital before turning a profit. Does that mean it’s not about profits for these businesses and that’s not their top goal? Of course not. That’s just crazy talk. The difference is simply this. These investors appreciate that their is profit potential when you’ve captured the daily attention of hundreds of thousands or millions of internet users. One particular story that caught my attention was the start of Hotmail. Initially Hotmail had no users, no website (didn’t even have the hotmail.com domain name) but they had an idea and managed to raise $300,000 for a 15% stake in a company with no customers or income or profits, in return for being the first company to come to market with webmail. About 2 years later, that initial $300,000 investment from the venture capital firm was turned into $60 million dollars as Hotmail was sold to Microsoft for $400 million dollars. Without going into the details, the power of a viral business model made this all possible. So our question is, how did the venture capital firm decide that a 15% stake in JavaSoft (which eventually became Hotmail) was worth $300,000? Negotiating. The only thing JavaSoft had was an idea. Through negotiating they decided the idea was worth $2 million and so 15% was worth $300,000. For the dozen’s of businesses I’ve mentioned above that have followed a similar trajectory, obviously there are hundreds that failed. Beyond that, Microsoft, has certainly profited far more than their original $400 million investment in Hotmail in the last 10 years so don’t ever lose site of the importance of profits. ๐Ÿ˜‰

Public Companies can potentially bring another set of rules. Firstly, you can’t buy a public company for less than it’s stock is worth. In other words, if a stock is trading for $10 and there are 100,000 outstanding shares, the business is worth $1 million dollars ($10 x 100,000) and you can’t pay less for it. In theory, the company’s stock price should be based on it’s profits (generally called earnings) however many public companies have price to earnings values ranging from 5:1 to 50:1 or higher. This simply means that the business is “worth” anywhere from 5 to 50 times more than its profits. If a business is currently losing money, it’s price to earnings ratio effectively doesn’t exist. So, for instance, if the business above had $100,000 in profits, it’s PE or Price to Earnings ratio would be $1,000,000 to $100,000 or 10:1. Make sense? So the natural question is, what determines a business’ stock price? And the answer to a great degree is the same as with an Internet Business. It’s based a lot on speculation. More specifically, if a bunch of people think a business is a great business, and so buy a lot of stock, the price of that stock will go up regardless of whether the business has profits or not. In theory, over the long-term the stock price will match the actual value of the company which is how guys like Warren Buffet have made billions investing in companies that are undervalued.

So what does this mean to us? If you have no profits but can convince a bunch of people you have a great business anyway, you can make a lot of money. ๐Ÿ˜€

The reality is actually, if you can convince buyers, venture capitalists, or investors that your unprofitable business has the potential to return remarkable profits in the future, you may just be able to throw EBIDTA out the window and value your business on whatever feels right at theย  moment. In other words, no matter where or what your business is, your business is worth whatever you can convince someone to pay for it.

To your success, Bryan

P.S. If you’re looking for a real-life argument between a small business “profit is king” entrepreneur and a “customers are king” large business builder, check out Perry Marshall’s blog.

Buying a business – Step 2 – The Broker

When buying a business for the first or even second or third time there are a few things to keep in mind to help you a long the way…

The first step is obviously finding a business. I’ve blogged before how I’ve found several offers to buy or otherwise acquire businesses in a short amount of time and even blogged about finding a business for little to no money down. In addition to those few examples, I mentioned 2 other great resources are:

Bizbuysell.com

Bizquest.com

Both have some easy to use tools to find the exact business you’re looking for. Keep in mind that the best businesses have a great Cashflow to Asking Price ratio. In other words, if a business has a cashflow of $100,000 you should want to pay as close to $100,000 (or less) as possible. Ideally you’ll pay less than 1 times Cashflow plus assets. So in our example with $100,000 in cashflow if they also have $200,000 in assets a price less than $300,000 would be quite a deal. ๐Ÿ™‚ย  Convincing the seller and a business broker of that might be a little more tricky so be prepared to justify your valuation. Keep in mind that business valuations can be quite subjective. In my experience, a broker can either be your best friend or worst enemy. If you are able to convince him you’re the man for the job, he’ll do his best to convince the seller you’re price should be accepted. Even though he represents the seller, he only gets paid if someone actually buys a business. It’s important to keep that in mind and use it to your advantage. Now how do you do that?

The game plan is rather simple. The trick (like usual) lies in how well you’re able to communicate it. ๐Ÿ˜‰

  1. Make sure he likes you. – This is important because he’s the gate keeper. Heck, he may even be “screening” potential buyers ahead of time. Without his blessing, you don’t see a Non-Disclosure Agreement or ever meet with the sellers. Be comfortable but confident in your discussions and if you find common ground, certainly use that to build rapport. If you get along well with most people and can speak coherently (even under pressure) this becomes second nature and not a step that even requires planning. Check out How to Win Friends and Influence People and Persuasion: The Art of Getting What You Want for more details.
  2. Make sure he thinks you can do the job. -If he doesn’t think you have the ability to run the business being sold you’re not going to make it very far. Be prepared for questions like “Do you have any experience in this type of business?” (he’s making sure you can actually get the job done), “Are you looking at any other types of businesses for purchase” (he’s determining your commitment and passion to this field), and “Do you have management experience?” (he’s assessing whether you can take over and lead a team effectively especially with the nuances of a new owner/leader). I’ve spoken with enough of these guys that I generally have preplanned stories in mind to respond. Always remember that stories that illustrate your capabilities are the best way to get your point across. If this is your first business purchase and you want to sound like an expert, read my blog, the Best 6 books to teach you how to generate wealth, and practice “interviewing” a few business owners to learn how they implement “book lessons” in the real world. Explanations for leadership styles based on books generally do pretty well with business brokers since they’re in effect consultants themselves. They get to look at and evaluate businesses every day without getting involved with what’s needed day-to-day so the perfect answers that you read in books are what they want to hear. For instance, when a broker asked me if I had any management experience I explained my philosophy on being a Team Leader instead of General Manager. He immediately interrupted me and said it sounded like I was a big fan of the Deming philosophy and Six Sigma and I had a great leadership philosophy. Now that he was on my side I shot back “So do you think my style would work well in this business?” – obviously looking for additional details that could help me in my negotiating.ย  His response was that for liability reasons he couldn’t respond specifically about how my philosophy would work however “it’s a proven philosophy that would do well in any business.” You think he liked me and thought I could do the job after that? ๐Ÿ˜‰
  3. Make sure he agrees with your valuation. – You always save this step for absolutely last. If the broker and owner trust you, thinks you’re capable, and you’ve done your preliminary due diligence and you still want to proceed you start working on explaining why you think the business is worth less than they do. This is possibly the toughest part, but it doesn’t have to be. In one business I was evaluating the owner didn’t have any cashflow or even profit and loss statements. For that reason it was very hard for me to value the business. Obviously it made it even harder for the broker to value the business which was something that rather annoyed him. So he recommended to myself and the seller that this should be an asset only transaction. The transaction never materialized however it was kinda nice to not have to do much negotiating that time since my goal would have been an asset only purchase as well. ๐Ÿ™‚ย  You won’t always get that lucky, so you need to spend a bit of time educating yourself on proper business valuation models so you can “talk-the-talk”. Check out my blog on why banks don’t know what your business is worth and my other one on EBITDA for more information. Simply low-balling with no justification or explanation is a bad idea. If you’re dealing with an individual who is selling on their own, chances are they have no idea how to truly value a business and so will be more apt to agree with you if you know what you’re talking about. Beyond that, one broker told me there are about 12 valuation models that are “commonly accepted”. With 12 valuation models, do you think they all work out to the business being worth the same amount? Of course not. The bottom line is cashflow and assets so make sure you stick to that. Business growth potential aren’t worth anything and should never be something you pay for.

That’s your quick overview of dealing with a broker (or even seller without a broker) on a business purchase.

To your business buying success, Bryan

Buying a Business – Step 1 – Finding the right business with little to no money…

These days it seems you can buy almost anything without having any money upfront. You can buy your fridge, computer, car, and even house with no money down (ok, the house is a bit trickier now then it was in 2006). However, did you know it can be done for businesses to? Depending on the size of the business that is very reasonable option. However, the larger the business the harder this is to accomplish. If nothing else, consulting fees to your lawyer and accountant (whom you should always consult) could prevent a No-Money-Down transaction on larger (i.e. greater than $100,000 transactions).

So how do you go about finding a business to buy when you don’t have deep pockets and investors lined up?

The most important part of that is finding the right seller. The only way you can reasonably buy a business with little to no money down is to find a seller willing to finance the deal for you.ย  As funny as it may sound, people don’t always sell a business JUST to make money. There are actually a lot of other items that can factor into a sellers decision of whom they want to sell to and for how much. The biggest factor in getting a LOW PRICE and OWNER FINANCING is the seller’s time frame. What that means is if someone needs to sell quick, you can get a much better deal. The same is true of anything you purchase. If someone needs to sell a motorcycle because they’re joining the military and being shipped out in 2 weeks you’ll obviously get a better deal then if they have all the time in the world. When you buy a house, car, or anything from a small business the same can be true and the same is definitely true when buying a business. So what are some common “flags” that you can use for bargaining leverage?

  1. Divorce – This may be the best one. Let’s face it, when people are getting divorced they need to get rid of things quickly and sometimes for very little money if for nothing else but to not allow their spouse to get the business. I’ve heard of one instance where a business owner literally gave his business away for free just so his ex-wife wouldn’t get it. ๐Ÿ™‚
  2. Illness – Sometimes people get sick (or someone in their family gets sick) and they can no longer adequately run their business. Often that requires them to get rid of it quickly or risk losing it completely. In one instance I looked at a business with this scenario. A month after visiting that business the owner called me back and said she’d go down on her price and finance the business for me because she just needed to stop working right away. I passed on that business even though the opportunity for a no money down purchase was there.
  3. Retirement – This is a very common reason for selling a business and one that can be a great tool for negotiating the price down or toward an owner finance package. You first need to find out if they’re an S-Corp, C-Corp or LLC. If an S-Corp that you’re willing to buy the shares of, they stand to have great tax benefits by receiving small payments over time versus one large payment. The seller may not know of those tax benefits so you can use that as leverage. Another important point with retiring sellers is that they may be tied emotionally to their business. So what does that mean for us? Well that means they are motivated by more than just cash. If the seller is also the founder they generally feel a tight connection to their customers, employees and business as a whole. They don’t just want some well heeled corporate raiders coming in to sell everything off and make a mess. They’re looking for someone who can continue their vision. And if it’s important enough to them, they may even consider the buyer who is perfect in every way, except they don’t have the ability to come up with cash. From their perspective if their business is taken care of and they are still getting as much or more per month than when they were working why not take the deal?
  4. Cashflow/Bankruptcy – What I mean by this is someone who’s going to lose their house because they can’t make payments may be willing to sell their business quickly and cheaply. Obviously the strength of a business whose owner is broke should be in question, however keep in mind that the best businesses to buy are the ones that have problems that you can quickly fix. The owner with cashflow issues may need money upfront or may just need X amount a month to cover some bills.

So when you’re evaluating businesses to buy, it’s always important to ask “Why are you selling?” A lot of websites, like Bizbuysell.com and Bizquest.com, even list the reason for selling right in the description so you can more easily cherry-pick the right ones.

Here are a few other important questions to start narrowing down your business choices:

  1. Why are you selling?
  2. Is the seller also the founder?
  3. Is he involved in the business day-to-day? If so, in what capacity?
  4. Is an individual or investment company selling?
  5. What’s your time frame for the transaction?
  6. What’s the annual cashflow or profit?
  7. Is the business a S-corp, C-corp, or LLC?
  8. How many full-time sales personnel?
  9. Marketing budget?
  10. Current marketing projects?
  11. Is real estate included? If not does the seller own it and plan to continue leasing? (This can tell you a bit more about the sellers total monthly income without a business)

It can take quite a while to find the right business so start searching now. I’ll continue to walk you through the lessons I learn as I continue to work on business acquisitions.

To your business buying success, Bryan

Business Valuation 2 – EBIDTA can eat my shorts…

Ok, so maybe that’s not the most professional way to title a blog… We can discuss that another time.

In the last blog we discussed the 2 main criteria a bank looks at for approving a commercial (and theoretically personal) loan.

  1. Cash Flow – do you make enough money to afford the payments?
  2. Tangible Assets – if you don’t make enough money what can we sell to pay off what you owe us?

Since that blog was written a banker educated me concerning listing revenue and a customer list as an asset “There is no way to assign a value because that customer base can decide to go away on a momentโ€™s notice. They are not required to do business with you. So that value in the business is actually a part of the โ€œblue sky.โ€” So you know I’m not making this stuff up. To think that customers are just going to disappear when, on average, each one has been with you over 8 years AND new customers are going to stop buying from you when you’ve had a successful revenue generating strategy in place for nearly 40 years is kinda silly. For most people their business’ are their lives. With that kind of track record how/why in the world would they all of a sudden sabotage it. That just seems like a ridiculously minor risk.

Does anyone know if banks are “forced” to not consider revenue or customer base as an asset because of some strange banking or FDIC regulations?

At any rate, we’ve spent enough time on valuing a business based on tangible assets so let’s consider valuing a business based on EBITDA. Firstly, EBITDA and cashflow are NOT the same thing. If you’re buying a business, you should always value it by looking at profits. Secondly, EBITDA in no way approximates or represents profits. I only point that out because if you’re trying to buy a business and someone tells you that it’s worth $1 million because EBITDA is $200k and the standard multiplier is 5 then you should indicate that EBITDA doesn’t tell you anything about the business and you need to look at profits instead. Let’s look at each piece piece of EBITDA so we can see why its only helpful when you sell your business (because it’ll drastically inflate the business’ value).

  1. Earnings – depending on who’s doing the evaluation this can be either Net Operating Income or Net Income. In essence, this is your “book” profits. Except there’s one problem. If your business is based on Accrual accounting (which over 95% are) then earnings are based on sales, not on deposits. Just because I made a $1000 sale, doesn’t mean I’ve actually collected $1000 and have that cash in my bank account to spend. In other words, this tells me what earnings should be but not how much of that is cash in my pocket.
  2. Interest – The theory goes that when you buy a business you’re not buying the business’ debt so you have to pull out its interest. That makes sense as long as you add back in the interest you’ll now be paying for whatever loan you need. If you’re just using EBITDA to measure “free cashflow” in a public company, you definitely don’t want to pull out interest because they have to pay that every month and that certainly affects their cashflow.
  3. Depreciation – The basic idea is that if you buy a truck, car, building, computer, or office equipment for your business, you can’t write-off that expense all at once and so have to depreciate it over 3,5,7, or 21 years depending on what it is. Well you had to pay for it upfront, so now you have a non-cash expense (i.e. an expense that shows up on your income statement that isn’t a part of payables) and more cash in your pocket every month, right? There are 2 problems with that.
    1. You generally still have mortgage or car payments to make that don’t show up on your Income Statement. So in this instance some portion of that depreciation IS actually decreasing your cash flow every month.
    2. Depreciation is designed to expense an item over it’s lifetime. However, at some point you’ll have to replace that item again. If its your habit to pay for everything up front without a loan then every month you’ll have to be setting some cash aside to replace that item when its useful life expires.
  4. Taxes – This one is similar to Interest in that when you buy the business you’ll have a new accountant and and so the amount you pay in taxes is going to be different. That sounds reasonable to me. So figure out how much in taxes your super-accountant will be able to save you and subtract that. Don’t just assume taxes are going to disappear and base your business valuation on that assumption. One way or another you will pay taxes – or end up like Al Capone.
  5. Amortization – The whole concept of amortization is probably the one I understand the least but here’s my explanation anyway. Admittedly, this one can be a very legitimate non-cash expense. I’ve discussed this one with business owners, accountants, lawyers, and bankers and, though they all seem to have a slightly different explanation, from what I can tell, it’s a GREAT accounting gimmick. Here’s how it works, it’s basically the same as depreciation except for non-tangible assets. For instance, let’s say you pay $1 million for a business but through certain accounting practices you can show the business is worth $600k. You now may have the ability to amortize that $400k “blue sky” asset, that has no “tangible” value, over the next 15-20 years. Now, if you are the one who is making payments on a $1 million loan then the amortization is just like the depreciation. It’s not really a non-cash expense since you’re making loan payments against it. However, if you buy a business where the previous owner was amortizing from his purchase, now you could potentially have 10-15 years left of that non-cash expense to write-off. This is most common when the previous owner bought the business when it was losing money (if you pay any money for a business that is losing money you should have some “blue sky” to amortize) and then made it profitable and sold it to you.

The Bottom Line

EBITDA has it’s place. In fact, it’s great when you want to sell your business. Most people in the business and banking world use EBITDA multiplied by some arbitrary number (generaly 3-9) to come up with the value of a business. Since that value will always be higher than valuing the business based on profitability, then why wouldn’t you try to sell your business based on that?

On the other hand, I’m not sure I can think of one solid business reason to evaluate a business based on an EBITDA, EBITA, or EBIT number. Maybe that’s why EBITDA is not a GAAP (generally approved accounting practice) calculation.

Nonetheless, you have to give it to the first guy who invented EBITDA by highlighting it in a corporate report to show how well his business was doing. We all bought into it and now he even has the banks and accountants using his inventive, creative, and pointless calculation.

Just make sure the next time you’re looking to buy a business or just some stocks, you’re not spending too much time on EBITDA.

To your success, Bryan

Business Valuation – Why banks don't know what your business is worth.

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:

  1. 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).
  2. 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).

My first house and rental propertyThat’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:

  1. The majority of business purchases are vendor financed so that may be an option.
  2. 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).
  3. 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