Buying into out-of-state business -vs.- Investing

[jumpie]

Hello,

I have two questions, one specific, one slightly open-ended regarding a situation where I have a chunk of money and two choices of what to do with it.

Option 1 is invest. Option 2 is buy into an out-of-state small business (retail store). The store is run by someone I trust and have known for 10 years. I'd be buying a 60% share in the store from this person (the other 40% is owned by someone else).

First question is what kind of financial planner/lawyer/CPA can I talk to about the pros and cons of buying the business? I'd like to talk to ONE person who has enough expertise in the relevant areas without having to bounce around between a lawyer, a CPA and a financial planner. (I'm in the San Francisco area if you have specific suggestions)

As for the open-ended question, I'm looking for advice on this kind of situation. My preliminary math seems to suggest that if the store continues to do as it has in the past, after about 10 years it would be better than investing at a 10% interest rate.

Say I have $100,000 to buy into the store or invest and the store would pay me $30,000 per year.

If I assume (over-simplified but good for comparison I think) 33% taxation on the business profits as well as on investment returns, I get:

Store: $20,000 net profit/year, so in 5 years, I made back the $100,000, in 10 years, that's $200,000

Investing: (assuming non-IRA of course) 10% returns minus 33% tax = 6.6% returns (compounded), so in 5 years $137,653 and in 10 years I have $189,483

(If I stash some of it in an IRA, maybe the investment option looks better? On the other hand, I can also start investing the store profits to bolster that option.)

Of course both scenarios have their risks of lesser returns, but is my basic math correct?

[ArcSine]

Just some shoot-from-the-hip comments, in no particular order...

Among the classes of advisors you've mentioned, each one potentially brings something to the table which the others cannot. The financial planner's forte would be helping you evaluate your "other investment" options. (Your 5- and 10-year compounded horizon value computations are correct, but over that time frame those horizon values are rather sensitive to the return assumptions. You might be comfortable rolling your own when it comes to weighing your investment options and optimal strategies, but a financial planner would be your go-to guy if you wanted a sharper picture of those options.)

In buying (or buying into) a closely-held biz, it's a very rare deal in which you wouldn't want an attorney's input. There are documents and agreements and waivers and disclosures and amendments and leases and loan covenants and ....... Personally I'd rather chew barbed wire and broken glass than drop 100K into a biz deal without having an attorney vet all the docs.

The CPA earns his beans and rice analyzing small-business financial statements, which is another very important aspect of any buy-in deal.

It's possible you could find all these necessary inputs all rolled up into one Brooks Brothers suit, but the reality is that all three arenas (financial planning, law, small-biz finance) are sufficiently deep that the best advice comes from those who practice exclusively in exactly one area. There are indeed exceptions to every rule, and you might be able to ferret out a single advisor who could give adequate advice (on a very simple, straightforward deal), but I can't advise you in that direction without knowing the case-specific details.

Moving on, one thing I'd suggest--if you haven't already--is to check any shareholders' / partners' agreement currently in place to make absolutely sure the sale of 60% of the equity faces no stumble-stones at all. Examples of such would include first-refusal rights or options held by the minority equity guy.

Since I'm on a roll mentioning things you've already considered here's another: Make sure your analysis gets you to a point of significant confidence that you fully understand why this fellow is willing to sell for 100K a piece of equity that's throwing off 30K per year pre-tax. That's just a 3 and 1/3 price-to-cash-flow multiple, which is usually associated with investments on the Wild West end of the risk spectrum. There may very well be good reasons for his pricing, but just make sure you're comfortable with the underlying rationale.

One other thing, in your comparison analysis don't forget to include some assumptions about the likely (range, at least) of terminal values for the business. In other words, the annual cash flow your equity investment would generate for you is but one element of your overall return; the other is the amount you'd realize upon the sale of the business (or, say, your subsequent sale of your equity to another party). If, for example, you did indeed receive the 30K per year you mentioned, and also cashed out of the deal later for your acquisition price of 100K, then you would indeed have realized a true 30% annual return on the deal. If instead you sold out for more or less than 100K, your overall annualized return would be greater or less than 30%.

Sorry for rambling around, but like I say it was just a few random thoughts-at-large. Cheers, and best of success with whichever direction it goes!

[jumpie]

It's possible you could find all these necessary inputs all rolled up into one Brooks Brothers suit, but the reality is that all three arenas (financial planning, law, small-biz finance) are sufficiently deep that the best advice comes from those who practice exclusively in exactly one area.

OK, that makes sense. Being new to searching out these kinds of advisors, are there better ways to do so as opposed to fishing on the Internet? My thought was to call the Small Business Association to ask for references.

Does it make sense that I could first visit a financial planner with help to make my (tentative) decision, and if I go with the business investment, then turn to a CPA and lawyer to help vet that the business option is really what it seems?

Moving on, one thing I'd suggest--if you haven't already--is to check any shareholders' / partners' agreement currently in place to make absolutely sure the sale of 60% of the equity faces no stumble-stones at all. Examples of such would include first-refusal rights or options held by the minority equity guy.

There is a right of first refusal, but my understanding of that is that it's just a matter of meeting with the other partner and making sure we will be able to work together so that he allows me to buy in. Is that not correct? Am I understanding you correctly that you're suggesting here that I make sure that there would be no obstacles preventing the actual sale from proceeding?

Make sure your analysis gets you to a point of significant confidence that you fully understand why this fellow is willing to sell for 100K a piece of equity that's throwing off 30K per year pre-tax. That's just a 3 and 1/3 price-to-cash-flow multiple, which is usually associated with investments on the Wild West end of the risk spectrum. There may very well be good reasons for his pricing, but just make sure you're comfortable with the underlying rationale.

Well, I've been signed up at several online business brokers for several months and have read several business prospectus documents, and this actually seems to be the normal pricing. I hear your concern (and really appreciate you bringing this up, since I have wondered about it), but from what I've been seeing, you can generally expect that to buy a business, you will need to pay anywhere from 2 to 4 times the annual gross profit. Does that make sense?

I find that an even more important (but similar) concern that needs to be vetted when buying a business is understanding why the owner is selling at all (never mind the price). That's why I'm keen on this opportunity, since the owner is a friend and I trust his reasons, whereas I've seen prospectus documents that claim "owner is moving on to other business" or "owner is retiring" or other things, and I have no way of knowing if the real reason isn't that the business is in decline.

One other thing, in your comparison analysis don't forget to include some assumptions about the likely (range, at least) of terminal values for the business

OK, that makes sense. Thank you.

Sorry for rambling around, but like I say it was just a few random thoughts-at-large. Cheers, and best of success with whichever direction it goes!

Are you kidding me? SORRY????? No no no!!! THANK YOU!!!! Your response was fabulous!!!!!

[ArcSine]

I appreciate the kind words, comrade, and I'm glad it helped a bit.

OK, that makes sense. Being new to searching out these kinds of advisors, are there better ways to do so as opposed to fishing on the Internet? My thought was to call the Small Business Association to ask for references.

That's a tough one to "rule of thumb" respond to, as every individual has a unique set of pre-existing circumstances. For example, you might have an accountant you've worked with before (your tax guy, say). Maybe he's not active in the small-biz-buyout arena, but he has an old friend from his Price Waterhouse days who has a small practice in the area, and who has advised on a number of acquisitions. Or perhaps an acquaintance of yours owns a business, and his accountant knows an accountant who....

Point is, I see people get their advisors via a wide array of channels, and your own good sense will likely be your best guide. An internet fishing expedition will certainly net a number of small investment banking firms who handle buy-side acquisition advisory, but the problem there is that they usually prefer deals larger than what you're contemplating, and hence their minimum fee would be too expensive relative to the size of your investment.

If you don't have some pre-existing connection into a small- to mid-sized CPA firm there's nothing wrong with the ol' Yellow Pages. Every such firm has certain areas they specialize in, and others they don't. Whittle it down to a list of 4 firms or so, who claim expertise in buyouts and small-biz valuations, and then spend a few minutes chatting with someone (preferably a partner) about your possible deal. In that chat you'll get more than just a fee quote; you'll also get that all-important vibe regarding the chemistry.

As a side note, any accountant or CPA who advises in this area will have an attorney (or two or five) with whom they've worked on many such deals, and who they'd be happy to recommend to you.

Does it make sense that I could first visit a financial planner with help to make my (tentative) decision, and if I go with the business investment, then turn to a CPA and lawyer to help vet that the business option is really what it seems?

Absolutely. Let the specifics of your situation tell you when you need to bring any certain advisor into the picture. The financial planner makes sense if your personal financial situation (outside of this proposed buy-in) is complex enough to warrant a planner. Alternatively, if you already have a trusted financial advisor for your personal investments (a stockbroker, say), then he/she might be a good first choice for this role.

There is a right of first refusal, but my understanding of that is that it's just a matter of meeting with the other partner and making sure we will be able to work together so that he allows me to buy in. Is that not correct? Am I understanding you correctly that you're suggesting here that I make sure that there would be no obstacles preventing the actual sale from proceeding?

You've already anticipated the first source of potential obstacles: any priority rights, options, or no-sale clauses built into the current agreement. Examine their agreement carefully to make sure that its specific terms are exactly as you understand them to be. There's also a second general class of obstacles which is sometimes overlooked: debt covenants. It is sometimes the case that a loan agreement will require that any major change in the control of the borrowing corporation triggers an immediate full-payoff requirement of the debt balance. If this company has any loans outstanding, check 'em carefully for any such change-of-control provisions.

Well, I've been signed up at several online business brokers for several months and have read several business prospectus documents, and this actually seems to be the normal pricing. I hear your concern (and really appreciate you bringing this up, since I have wondered about it), but from what I've been seeing, you can generally expect that to buy a business, you will need to pay anywhere from 2 to 4 times the annual gross profit. Does that make sense?

And that was exactly my point, although I didn't make it well. Just as you've seen, those kinds of low multiples are associated with businesses which have a high uncertainty level as to their future earnings streams. This implies that the 30K / year figure you mentioned is probably subject to a fair amount of uncertainty. Nothing wrong with that at all, that's typical of most small (and many large) businesses. I was just pointing out that if the tentative pricing here is in the neighborhood of 100K, it implies that the 30K is far from certain. Which in turn means that some extra care must be taken in comparing your alternatives, as two opportunities, one with a very low-risk, nearly-certain return, and another with a significant degree of uncertainty as to its future return, are definitely an apple and an orange, for comparative purposes (at least until you've made appropriate allowances in your computations).

As a side note, in looking at deal pricings, take care to distinguish between multiples of "gross profit" (as you mentioned) and "net" something (earnings, cash flow, etc.). Gross and net are usually pretty different, and a deal priced at 4x Gross Profit might be equivalent to 10x (say) of Net Profit. Biz brokers like to quote on multiples of GP (and buyers frequently prefer to have the pricing based on GP as well) since the operating expenses (the difference between GP and Net Profit) are usually rather subjective---many of the operating expenses are at the whim of the owner, and a potential buyer figures he'll be changing the expense structure of the company, post-acquisition, anyway.

I find that an even more important (but similar) concern that needs to be vetted when buying a business is understanding why the owner is selling at all (never mind the price). That's why I'm keen on this opportunity, since the owner is a friend and I trust his reasons, whereas I've seen prospectus documents that claim "owner is moving on to other business" or "owner is retiring" or other things, and I have no way of knowing if the real reason isn't that the business is in decline.

You're spot-on with this one, and your "insider's" knowledge of this deal will be a substantial asset to you if you decide to pursue it.

[Yigal]

On a different note, when a business is sold you need to specify what is sold, these can make big tax differences both to the buyer and the seller. good will, non compete, customer list and other items change how pays the tax and at what rate. I advice to look into that as well.

[vip]

I agree with yigal

[jumpie]

@Yigal My understanding is if you can structure it as an asset sale, where your business is merely buying another's property, you can write it all off as a business *expense*. I'm not sure I understand why the IRS would care (give different rates/structures) depending on things like whether or not a sale included a non-compete agreement or a customer list (??).

The specifics of my case are that I'm buying *into* a business, not buying it out 100%, so I unfortunately don't have any of those options and unless I'm misunderstanding something, I'm looking at the prospect of getting no tax breaks on the sale at all.

Thanks to everyone for the very helpful responses (sorry for the delayed reply).

[ArcSine]

Jumpie, even with a 'partial' acquisition as you've described, there still might be some tax planning opportunities. It really depends on the specifics of the situation and the objectives of the parties, and you'll want an experienced tax advisor at your elbow (one who has expertise in buyouts and deal structures).

Also, the buyer / investor and the seller are frequently at cross purposes when it comes to the actual structure: What's better for the former is suboptimal for the latter, and vice-versa. As you've probably heard or read, a buyer typically prefers to acquire assets whereas the seller prefers to sell stock. The former structure type usually generates greater depreciation write-offs in the coming years for the buyer, while the latter structure typically produces a more favorable capital gain treatment for the seller. (Thus it's not exactly that the buyer can 'write it off' as a biz expense with an asset purchase, as you've mentioned, but it's still usually true that an asset purchase produces a little more after-tax value for the buyer.)

Similarly, in an asset deal the buyer usually prefers a greater proportion of the price to be allocated to rapid-writeoff type assets (inventories, e.g.) while the seller comes out better with a greater proportion going to longer-life, capital gain type assets (goodwill, e.g.).

But as I mentioned, these differences might still be a factor in a 'partial' acquisition or buy-in. Just to make up an example, you form a new holding company and fund it with your buy-in cash. Step Two, Holding Corp acquires 60% of the assets of the existing company with the cash, while the existing company contributes the remainder of its assets to Holding Corp in exchange for 40% of the stock of Holding. Finally, the existing company liquidates, putting the 40% ownership of Holding Corp into the seller's hands.

Like I say, it's a purely made-up illustration, but it's typical of a structure that's commonly used, and it illustrates how even a 60% buy-in might be framed up in a way that introduces tax planning possibilities.

Bottom line: have your advisor examine the details and listen to the parties' objectives. Tax benefits might be in reach, hiding just behind a little creative deal structuring.

[jumpie]

Ohhhh, I see. So there's a lot more creativity that can happen. Definitely time for me to see a CPA and lawyer!

Thank you!

[Richard Thompson]

I saw a number of conversations are made providing great information about buying a business. All I can suggest you is to have a lawyer who specializes in leases and business sales go over everything. They can address your concerns the best as well as protect and provide you with other advice concerning the business. It will be the best money you spent whether you go through with buying the business or not.

Thanks.