Business Insights

Business Acquisition from a Banker’s Perspective

When a borrower approaches a lender with a loan request to acquire a company, it initiates a process designed to help the buyer and bank evaluate this life-changing business opportunity. Banks utilize this process to assist the buyer’s evaluation process and to be a sounding board for the buyer. In general, the banker’s view will be oriented around the following:

Buyer Evaluation For starters, an objective banker evaluates an individual’s personal wherewithal: how an individual has overcome challenges and pursued objectives with sustained determination. In her New York Times Bestseller Grit, Angela Duckworth quantified an individual’s ability to persevere and achieve long-term goals. Her book suggests that while IQ is important, an individual’s conscientiousness is a greater predictor of success.

Due Diligence Driven by an industry with low tolerance for loan losses, bankers can be seen as pessimistic. It is their job to consider the numbers and how they would look if things were not all sunshine and rainbows. If a downward economic cycle occurs, is the financial information provided by the company a reliable source of data to make the necessary financial decisions? A financial evaluation is important; however, understanding the acquisition target’s cyclicality is also important. For example, commercial construction in general tends to lag economic cycles while businesses tied to consumers tend to lead economic cycles. Bankers will drill down to the micro-economic factors that apply to a business’ specific situation to give this deal the best chance of success.

Loan Structuring Cash flow is the largest determinant of the business’ ability to repay a loan and often determines how a loan is structured. Loans are structured based on the risk assessment and due diligence findings from the lending team. Loans made based on the cash flow of the business typically have shorter (ideally 3 years or less) amortizations whereas loans with appropriately margined collateral may extend beyond this. There are various structuring options that combine both options, so it is not just one of the other. If a company has excess cash flow, bankers could include a clause to decrease the principal balance by capturing this cash flow. A key to success at this point is transparency. It is important to find a banker that will be transparent with you and include you in the discussions to allow both parties to make an informed decision.

Collateral Evaluation In addition to the buyer evaluation, a banker evaluates the marketability of the collateral supporting the loan if cash flow deteriorates materially, and the collateral is needed to repay the loan. For example, a titled asset may be more marketable than a paint booth in a manufacturing plant. The loan to value ratio will be lower for less marketable assets. To properly identify the value, appraisals (equipment, property, etc.) are often used to substantiate the collateral value used. To further protect their financial interest, banks will typically require a first lien position on all collateral.

Approval Whether by a committee or individual signer, loan approval is a key element of the entire process. As much as the bank is responsible for diligent throughout the process, the buyer must also understand the bank’s (or the credit approver’s) background in financing Merger and Acquisition transactions. There are subjective factors that are relevant in commercial lending, and even more specific nuances are prevalent in acquisition financing. It is important to ensure your bank is equipped to offer the financing and support you need.

Funding It is not unique that an approval contains contingencies for funding the loan. These could include minimum revolver availability at closing, verification of liquidity, or receipt of an appraisal. Once the documents are signed and the loan funded, these items are typically monitored and require ongoing loan reporting on the borrower’s part.

Post-Close Management After closing, the bank will likely want to maintain regular dialogue with the borrower. Depending on the loan size and loan structure, the borrower will have ongoing reporting requirements they will owe the bank. If the deal is structured properly, it should create a lasting, mutually beneficial relationship.

Written by Aaron Schaffer

Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
March, 2024

Will It Be a Buyer's Market or Seller's Market for My Business?

The California Association of Business Brokers indicates that Baby Boomers own more than 12 million small businesses in America. Over the next 10-15 years, many of these businesses will need to transition to the next generation or to a new owner as Baby Boomers look to retire. If one assumes the long end of the 10-15 year range, this means that 800,000 businesses will transition each year for the next 15 years. For further context, according to BizBuySell, only 9,093 businesses were sold in 2023. Increasing from 9,093 to 800,000 businesses selling annually is an astounding 8697.98% increase. The question is how much capital is available to support these transitions?

Historically, buyers are key management personnel, wealthy individuals, families, groups, or private equity firms. As of December 1st, 2023, there was a record $2.59 trillion in cash held by private equity firms globally. In 2022, that number was $2.237 trillion. Despite an unprecedented amount of capital available, deal activity in 2022 & 2023 remained sharply down from its peak deal value in 2021 of $2.130 trillion. In 2023, the overall value of private equity transactions declined even further from $1.4 trillion in 2022 to $776 billion. As mentioned earlier, there are various options outside of private equity firms when it comes the sale of a business. While the private equity capital pool expands, family wealth offices are growing in popularity also.

A family wealth office is a privately held entity that manages the financial affairs of wealthy families. In general, these offices have over $50 million in investable assets. An extreme example is Walton Enterprises, the family office of the late Wal-Mart founder Sam Walton, whose heirs have a combined wealth of $224 billion. A recent survey by CNBC indicates that there are approximately 144 family wealth offices in North America, averaging $1.3 billion per office; this totals to $187.2 billion in wealth available to purchase businesses. When you combine the dry powder of private equity firms and family wealth offices, it appears to present an ample amount of capital to support the exiting business owners; however, there is a catch.

The firms and offices mentioned above tend to target acquisition deals with minimum price tags of $100 million. Additional headwinds to sellers include higher interest rates, which require higher rates of return for buyers (translating to a lower price for sellers) and robust due diligence process requirements of buyers. It will be hard to ascertain the amount of capital that will trickle down to lower middle market, Baby Boomer owned firms. In the near term, private equity sized transactions between sellers and buyers appear to have the funding available to support a balanced market; however, as more businesses become available for sale, the funding environment could change quickly. Given the volume of businesses looking to exit, a change in funding availability would likely favor buyers more than sellers.

Written by Aaron Schaffer

Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
March, 2024

Key Ratios to Consider in a Business Acquisition

Purchasing a business requires multiple sources of capital. Typically, businesses are purchased through some combination that includes seller financing, subordinated debt, senior or bank debt, and equity. When deciding how much cash to put into the purchase versus how much to borrow, it’s important to use ratios. Below, some ratios are described to help guide your acquisition towards being appropriately structured.

Cash Flow Measurements:

Debt Service Coverage Ratio (DSCR) compares the business’ cash flow to its debt payments. A DSCR ratio of 1.20 is a common minimum target; the higher the debt service coverage ratio, the better.

Senior Debt to EBITDA implies how many years it would take to pay off debt balances if all cash flow generated by a business was used to pay down debt. In general, a ratio of less than 3x is considered acceptable; however, highly cyclical industries tend to have lower leverage tolerances. A ratio approaching 5 is considered high and is usually cause for concern.

Balance Sheet Measurements:

Current Ratio compares a company’s assets available in 12 months or less that are available to pay liabilities due in 12 months or less. A ratio higher than 1.25 is preferred. Additionally, lenders look at inventory history, as this ratio can be skewed higher by an entity that is carrying a lot of inventory.

Quick Ratio amends the current ratio by only comparing readily liquid current assets – eliminating assets such as inventory or advances to shareholders – and comparing the liquid assets to current liabilities. As a reference point, a ratio above 1.00 is preferred.

Debt to Tangible Net Worth illustrates how a business is funded. By comparing the amount of debt invested to a company’s tangible net worth, an investor (or lender) can compare who has more capital at risk. Different forms of capital – debt, equity, subordinated debt – have different expected returns. Newly acquired companies or companies that have acquisition histories have a higher debt to tangible net worth ratio.

Written by Aaron Schaffer

Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
February, 2024

How Do I Buy a Business?

Last I checked, there are approximately 33.2 million small businesses in the United States, representing 46.4% of private sector employees. These businesses generated a total of $13.3 trillion of revenue or a simple average of $400,000 of revenue per firm. The revenue range of these firms is typically between $1 million to $47 million, employing up to 1,500 people. Needless to say, there are a lot of really good reasons to buy a business! Most sellers in this space care about 3 things: value of the sale, continuity of their life’s work, and protecting their employees. Buyers consider these along with considering if they are purchasing an entity with an investment return appropriate with the level of risk associated. This is not like buying a car, and to individuals unfamiliar with the process, purchasing or selling a company could appear to be a daunting undertaking.

The first step is understanding if you even could buy a business. Fortunately, Merger and Acquisition (M&A) professionals look for a consistent data set in qualifying potential individual buyers. Practitioners – particularly investment bankers and business brokers – will ask questions to validate the buyer’s qualifications and level of preparedness. Below is a sampling of these questions:

How much equity do you have to invest?
If you’re buying a company, per Small Business Administration (SBA) requirements, you will be expected to contribute 10% of the purchase price in cash. Having cash on hand of $250,000 - $750,000 will separate you from other buyers. If you don’t have that much cash on hand, you’re not out of the game just yet. There are ways to bridge an equity gap with subordinated seller financing.

Where is the equity coming from?
While it would be nice if we all had anywhere from $250,000 - $750,000 laying around that we could use to buy a business, that’s not the expectation. There are ways to use your other assets to support a business acquisition. For example, retirement funds are great collateral for starting or buying a business – and you shouldn’t incur penalties even though the money is being used prior to retirement age.

Does the buyer have previous, relevant management experience?
Dreaming is good, but such a large purchase does need to be grounded in reality at times too! Go where you know! Bankers and brokers are looking for alignment between your background and the business you are purchasing. While not a glaring red stop sign, this does cause a caution sign to go for up M&A professionals if these are out of alignment.

Have you bought a company previously?
This is not to say if this is your first purchase, you won’t be successful. M&A professionals are definitely prepared to be helpful, but there is a preference for individuals that have purchased companies historically. Just like in everything, if you’ve succeeded before, you’re a safer bet – but not the only bet!

In addition to a validation process, there will be some costs associated with buying a company. These due diligence costs can appear punitive; however, they are designed to uncover risks that may be outside of your expertise. Below are the costs in addition to an estimate for your general planning:

Keep in mind, the above list does not include other common costs that might include loan origination fees, SBA guarantee costs, or others related to obtaining a business acquisition loan. As a quick reference guide, here is how I typically estimate the first two fees.

Loan Origination Fees: tied to the size and complexity of the transaction.
SBA Guarantee Fee: driven by the SBA loan size; $2,000,000 SBA loan would have an estimated fee of $23,000.

The business buying process is much more nuanced than can be outlined in a blog; however, Community State Bank has a team of experts that can assist individuals looking to buy a company. Please reach out to our commercial banking team to start the conversation.

Written by Aaron Schaffer

Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
January, 2024

The Silver Tsunami and Succession Planning 

The term “silver tsunami” references the rapidly aging populations of developed countries around the world – the United States is no exception. By 2030, the Baby Boomer generation – about 76 million strong – will be at or beyond retirement age. Around this time, it is estimated the US population over 65 years old will outnumber those under the age of 18. This population shift has implications for small businesses, as 41% of the small businesses are owned by Baby Boomers. While recently many boomers have delayed full time retirement, whether due to the impact of the Great Recession or COVID, a large segment of the population will be focusing on transitioning their business in the coming years as they prepare for their next phase. While the concepts related to succession planning are simple, the execution of it rarely tends to be easy. These statistics alone are enough to get you wondering!

• Less than 1 in 4 private company boards say they have a formal succession plan in place according to the National Association of Corporate Directors.
• Per Deloitte, only 30% of family-owned businesses survive to the 2nd generation – 12% to the 3rd, and 3% to the 4th and beyond.
• According to a University of Connecticut Family Business Program, the death of the founder preceded 47.7% of business failures. Similarly, 29.8% of businesses failed after the unexpected death of the owner.

Succession planning is designed to help business owners understand how their business is valued, how to preserve and grow its value, and how to successfully pass the business on to others intact. If there is anything in you that wonders if you should have a succession plan, the best thing to do is act now. At least start the conversation as there are a lot of steps you can take to encourage success before the actual sale occurs.

For example, your business would typically undergo an assessment that reviews the business strategy, managerial talent, corporation structure, and external economic environment. Some founder operated businesses don’t naturally have the corporate governance expected to realistically continue or scale the business without the founder at the helm. Believe me, this is better to find out now and not 2 or 3 years into a new leader! Owners will need to ask themselves, “Do the personality profiles required by key positions align with the profiles of your successor?” It is not often in a sale of a business that an acquirer’s operating rhythm is the exact same as the sellers’ - even between family members. As long as you and the new leader are aware and prepared to manage this, it is not bad, but it can create friction between the old and the new. A great place to start is long before the sale is finalized. Maybe there are practices you and your current management team can adopt prior to the sale that would reduce the transition pains to the new style?

It’s important not to forget about how all of this will affect the exiting owner. Planning for a life post-business incorporates a multitude of new responsibility, including planning an estate, creating trusts, identifying charitable giving opportunities, preserving familial harmony, income tax management, investing post-sale liquidity, and ultimately finding purpose beyond the business. Additionally, sale transactions approaching $50 million or more may require the establishment of a family wealth office to oversee financial affairs into the future.

It’s worth mentioning that the business transition does not have to occur all at once. Some owners actually prefer to retain their equity while new management is running the company. Owners ready to have a partial liquidity event today may consider selling a minority stake in their company or pursuing a dividend recapitalization. Simply put, selling a minority stake means still having a liquidity event and getting paid out partially while still retaining control. On the other hand, pursuing a dividend recapitalization achieves the liquidity event without equity dilution but adds unproductive leverage to the business. These strategies could help facilitate the creation of a foundation, family wealth office, or provide a financial partner to accelerate business growth.

There are numerous resources – books, consultants, trade organizations – ready to assist with succession planning. The bankers’ role in this process is to connect others. At CSB, we have been able to help owners think through this simple but not easy transition and add value through our collective experience. Reach out to us today to see if our team can help you and your business!

Written by Aaron Schaffer

Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
February, 2024

Fortifylife Receives $600,000 Grant

Auburn, IN | December 27, 2023 — Fortify Life, a DeKalb County based non-profit organization, has announced a partnership with the Federal Home Loan Bank of Indianapolis and Community State Bank.

As part of this partnership and the Affordable Housing Program, Fortify Life has been awarded a grant for $600,000 to provide much needed renovations to Fortify Home, a local emergency and intermediate housing facility in Auburn.

Through the collaboration of many non-profit organizations in DeKalb County, it was identified that homelessness and housing crisis needs were grossly unmet. Fortify Life wanted to be part of the solution.

In 2021, Fortify Home opened its doors, and it continues to support individuals and families from DeKalb County who are experiencing a housing crisis. Currently, the facility offers 13 rooms. For the program Neighbors, these rooms represent a fresh start. Here, they partner with Fortify Home team members to address basic needs such as food and health care before focusing on long-term goals such as employment, child care, and ultimately, stable housing.

Most Neighbors participants spend five to six months at Fortify Home before transitioning to permanent housing. While the work done through Fortify Home is impacting lives by itself, they also pride themselves on being one of the very few shelters in the region that allows family units to stay intact during their stay.

“When we think about homelessness in DeKalb County, it isn’t the image we see on national news; there aren’t tent cities and camp sites in downtown Auburn,” said Mitch Figert, executive director of Fortify Life...

Read the Full Article at KPCNews.com.