Between now and 2024, some 5,700 to 10,000 businesses may close their doors due to the retirement of their owner. Fortunately, more and more young people are interested in business acquisition. But financing their ambitions remains a major challenge. Here are some tips.
There are two ways to become an entrepreneur: create a business, or buy an existing one. Today, over 65% of young entrepreneurs and professionals would like to take over a business, according to a study on business succession published in 2017 by the Rassemblement des jeunes chambres de commerce du Québec (RJCCQ).
The good news is that an aging Quebec population also means that thousands of entrepreneurs are retiring and leaving the business world. In 2018, these departures are estimated at around 25,000 province-wide.
So it comes as no surprise that young people are taking a close look at business acquisition. One of the advantages is that you can bypass the startup phase, with its unpredictability and its costs, including, potentially, product development. In an acquisition, the company already has customers, suppliers, processes and income that the buyer can count on while rebooting the business.
Of course, the road to success requires careful planning of the takeover. And the number-one challenge is financing. Buying a company and financing the elements that will allow it to grow involves significant costs. That’s clearly a concern for prospective buyers: 69% of young entrepreneurs surveyed by the RJCCQ said that access to funding is an obstacle to business acquisition.
Here are the key steps to overcome this challenge and develop a solid acquisition strategy.
It’s not easy to estimate what a company is worth. This is particularly the case in sectors where tangible assets (buildings, equipment, inventory, etc.) are minimal.
One simple and effective way to come up with a valuation is to analyze the company’s earnings before interest, taxes, depreciation and amortization (EBITDA). A three-year history will establish an average. This EBITDA average shows what the company currently derives from its operations before the impact of the financial and tax structure in place, and allows you to know what it will be able to generate in terms of cash flow.
In the current context, a transaction worth four to five times EBITDA can be considered acceptable. If the asking price is more than five times EBITDA, it’s probably too high. If it’s below four times EBITDA, take the time to carefully analyze the situation: The company may be hiding something. Obviously, the price of a company in a growing sector could be higher than five times its EBITDA, while a company in a declining sector will be worth less.
In all cases, it’s essential to keep in mind that every deal is unique and that the price will vary according to the potential for growth, recurring revenues and profit margin.
A balanced transaction is one where the risk is shared by several different stakeholders. First, you will need a down payment to cover a portion of the transaction. This will show that you are committed to the project. You and your backers or shareholders will also need to demonstrate your ability to reinject funds into the company if the actual results are not what you had originally forecast.
The seller may then agree to a balance of sale price. This is where payment of a portion of the amount of the sale price is deferred, and the terms of that payment are clearly defined. This most often occurs in situations where the seller also agrees to stay on with the company for a given time, which can make for a smoother transition for the employees and customers. It’s in the seller’s interest to cooperate with the buyer to ensure a successful transition of power and thereby derive the maximum from this balance of sale price.
Once you’ve determined the value of the company, and the sale price and the terms of payment are agreed upon, it’s time to turn to a financial institution to secure a loan, generally for a term of 4 to 10 years.
To convince a financial institution to back you, you first must present a viable financial plan. The main calculations that institutions perform when they’re considering financing an acquisition based on generated cash flow are as follows:
This is a performance ratio that makes it possible to determine the number of years the company will need to fully repay its interest-bearing debt. Ideally, the ratio of interest-bearing debt to EBITDA should never be greater than 3 to 1.
This other performance ratio shows the company’s ability to cover its fixed costs, commitments and obligations. The ratio should be around 1.25 to 1. Below a ratio of 1 to 1, the company is no longer in a position to meet its financial and business obligations.
EBITDA – (unfunded capital expenditures + taxes paid + dividends paid)
Annual debt (principal + interest)
Beyond the numbers, it’s important not to overlook certain non-financial aspects. Experience and expertise are two major considerations. You must possess entrepreneurial qualities and technical qualifications related to the field of business of the company you’re purchasing. Financial institutions also place great importance on management skills. The market and the industry are also analyzed.
To show that you are serious and well-prepared, bring the following when you meet with your advisor
Many companies will be put up for sale in the next few years in Quebec, and business acquisition has numerous advantages. Securing financing remains a significant challenge. But careful preparation and a well-structured plan can simplify this critical step. Your advisor can guide you through the business acquisition process.
Sophie, who holds a degree in family medicine, wants to present a purchase offer for her aunt Andrée’s private clinic.
First step: She calculates the average EBITDA over the last three years. It is $500,000. Her aunt wants to sell the clinic for $2 million. The price therefore equals four times EBITDA, which is perfectly acceptable in the context of a stable and loyal clientele.
Satisfied with that, Sophie can now think about financing her purchase. Her down payment amounts to $200,000. Her aunt has agreed to a balance of sale price. Their agreement stipulates that an initial sum of $1.5 million will be paid when ownership of the company is transferred. Then, Sophie will pay the balance – $500,000 – in 12 instalments of $41,666.66 over a period of 24 months. Her aunt has agreed to stay on with the business for one year. Sophie’s financial institution will give her a loan of $1.3 million over four years to close the transaction.
After 12 months in operation, Sophie will have already repaid $325,000 of her bank debt. Her balance will therefore be $975,000. The balance of sale price is not considered as debt, since it does not have to be paid in the following year. With an EBITDA of $500,000, her ratio is 1.95, and thus well below the maximum.
In her second year of operation, Sophie must repay $325,000 of the principal and pay $75,000 in interest on the loan. Using the clinic’s liquidity, she plans to pay herself $20,000 in dividends and also purchase $20,000 of furniture for the waiting room. The dividends and the furniture will have to be subtracted from EBITDA ($500,000 – $20,000 – $20,000). This leaves $460,000 / $400,000 = 1.15, which is insufficient. Sophie will therefore have to limit the dividend or finance the purchase of the furniture.
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