How Banks Affect Business Value!!

I THOUGHT MY BUSINESS WAS WORTH $2,000,000

For most businesses sold in America, the buyer has to rely on bank financing to fund the majority of the purchase price leaving a few dollars for an equity contribution to the purchase price. Banks have very strict credit lending standards, and typically look for three sources of repayment: Cash flow, Collateral, and Personal guarantee. What banks don’t tell you is that the primary governor on the availability of a loan is collateral.

Loan amounts are based on collateral values, then cash flow coverage. Furthermore, banks hold the cards in terms of what is acceptable collateral. While a buyer or you as the seller might think your customer list is the largest component of value for your business, this means nothing from a collateral support to a bank. In other words, if I took your customer list to a bank and asked for a loan they would simply laugh.

Banks best form of collateral includes account receivables, raw or finished goods inventory, fixed assets, and real estate. All other assets are nice and perhaps valuable, but not to a bank. Banks, however, like to margin against the full value of the assets, something called an advance rate. Yes, that’s right a bank will not lend to you 100% of the value of your assets (not even CASH). The following table shows the range of advance rates for each asset:

Lending Institutions Asset Advance Rates


Advance Rate Range
Asset Low end High End
Cash 90% 100%
Account Receivable 60% 85%
Raw and Finished Inventory 25% 50%
Fixed Assets 75% 90%
Real Estate 70% 85%


So what does this mean to you, the seller. Well if your available buyers are looking to rely on bank financing to buy your business, the buyer would be required to come up with a substantial down payment to facilitate the difference between the asset value and the advance rates. The ability of the buyer to raise this money creates risk for you in terms that you perhaps never thought of.

Example:
Let’s assume that you and the buyer agree on a purchase price of $2,000,000. Your business earns $600,000 in annual cash flow. This would create a 3.3x multiple. You feel that this multiple and value fully captures the essence of your business. However, the buyer is looking to borrow from a bank to fund the purchase price. So let’s look at the following scenario:

Asset Asset Value Advance Rate Net Lendable Value Purchase Price
Account Receivable $300,000 80% $240,000 $2,000,000
Finished Goods Inv. $200,000 50% $100,000
Fixed Assets $100,000 90% $90,000
Real Estate $500,000 75% $375,000
Totals $1,100,000 $805,000 ($1,195,000)

As you can see, the buyer would have to come up with $1,195,000 in cash to cover that shortfall from the bank. This is a difficult proposition for most buyers for companies of this size. While there might be specific State or Federal (SBA) programs that might increase the advance rate for each of these assets, the impact will not move the needle in a significant way.

So the buyer has three options: Bring in a partner, Walk away from the transaction, or Seller financing. In most situations the sellers are asked to provide seller financing to bridge the gap ($1,190,000) in the above example. So let’s say that you agree to finance the gap, and you and the buyer sign a ten year $1,195,000, 10% note subordinated to the bank, that’s right subordinated to the bank. This means that the bank gets its money before you and in the event of liquidation they get the proceeds before you do.

At closing you receive $810,000 in cash and a $1,195,000 note earning interest at 10% but doesn’t amortize until five years from closing. In total. you received $2,000,000 in consideration, but not $2,000,000 in cash. Using a 10% discount rate over ten years, the present value of your note is really $439,594.00. The following table shows the real value of your business, driven mostly by the advance rates of today’s financial institutions:

What’s my business really Worth?

Consideration Total Consideration Adj. Consideration
Cash $810,000 $810,000
Note $1,190,000 $439,594
Total $2,000,000 $1,249,584

So what started out as a $2,000,000 purchase price, turned into real consideration of $1,249,584 – a $750,000 difference. Wow, bank financing does affect the value of a business.