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Buying a Business With Its Own Cash – And Not a Penny of Your Own
After reading this article, you’ll be ready to start applying your knowledge and achieving your American dream of business ownership. This comes with serious effort on your part; but by reading this article I assume you have decided to take this long journey and start changing your life. I’m going to show you some simple ways to get the money you need using the modern miracle of leverage. We’ll start with an approach that allows you to actually make the business pay for itself without having to reach into your wallet.
Question: Is it true that the method of extracting money from a company’s cash flow is reserved exclusively for financial gurus?
Answer: Partially true. Most leverage techniques have this reputation. And frankly, you shouldn’t. If more people knew about them, many entrepreneurs would have been in business a long time ago. Such techniques seem to be reserved only for financial professionals because [the techniques] they appear more often in strategic financial markets. You’ve heard of many mega-billion-dollar acquisitions. But you’ll never hear how it happened or what was involved. This information is never made public. As discussed in Strategy 4, developing a strong network with business leaders will ensure you have access to this valuable information, even though you may not be working in the field.
These are actually hidden secrets that I am revealing to you right now. The power of information will allow you to go far. However, it is up to you to do your best to find out more information about the company you want to take over. Remember, the most powerful tool you have when dealing with a seller is to demonstrate your knowledge of the industry and how it can benefit them (and you, of course) if they sell you the business. And believe me, you too can start using these powerful yet simple tools right away.
Question: What is the easiest way to explain how to use a company’s cash flow for financing purposes?
Answer: Let me start by giving you a perspective on how much money we are really talking about. One expert explains it this way:
“The amount of cash that the average company puts into its coffers in just two or three weeks is usually enough to cover the down payment to buy that company.”
Think it over. The cash collected in just a few days is usually enough to settle the seller’s deposit with some creativity. This can work no matter what type of business you do. Since there’s no law that says you can’t “borrow” that money, all you have to do is figure out how to use the cash you’ve raised to pay for the business once you’ve acquired it. This is easy if you have a CPA to calculate your cash flow so you know how to approach the seller with your pitch.
Question: How does the process work?
Answer: You need some steps. You or your CPA should determine the net cash flow generated during the first few weeks of business by determining the difference between total cash receipts and operating expenses.
Question: What are the correct procedures for evaluating a company and what should I prioritize in my decision?
Answer: Several methods are used to evaluate companies. Usually, cash flow, assets, or replacement values, or a combination of these, are considered when valuing a business. Below are the various valuation methodologies commonly used by valuation firms.
Replacement cost analysis:
o In general, enterprise value does not refer to the replacement value of the company’s assets. Sometimes the replacement value of property, plant and equipment (PP&E) is much higher than the fair market value of a going concern. Sometimes the value of goodwill such as customer relationships, company logo and technical expertise is much higher than the replacement value of PP&E.
You can often choose to enter a particular industry by expanding facilities you already own, investing in brand new facilities, or by purchasing all or part of a new business operating in the industry. Deciding which investment to make depends in part on the relative costs of each. Of course, when determining where and how to invest, an investor will often consider capacity utilization, location, environmental, political and legal issues, among other things. These issues may outweigh the importance of replacement cost analysis; in such cases, this valuation method is not used to determine the fair market value of the business.
Asset Value Analysis:
o In general, it is possible to liquidate the company’s PP&E assets and after paying off the company’s liabilities, the net proceeds would be added to the company’s equity. It must be determined whether such a liquidation analysis should be performed on the assumption of a swift or orderly liquidation of assets. However, even assuming an orderly liquidation of the company, it is generally accepted that the operating company will have a significantly higher value. The asset valuation method is not suitable in this case because the company is doing business successfully; in such circumstances, in the industry in which the company operates, the fair market value of the company will almost certainly exceed the value of its assets in liquidation. The sum is worth more than the parts. It is appropriate to value non-operating assets using the asset valuation method to determine their value as part of the fair market value of the business.
Discounted cash flow analysis.
o Another factor in the value of a company is the expected cash flow. Discounted cash flow analysis is a valuation method that isolates a company’s projected cash flow available to service debt and provide a return on equity; the net present value of this free cash flow to equity is calculated over the forecast period based on the perceived risk of achieving such cash flow. In order to take into account the time value of capital, it is usually appropriate to value a company’s cash flows using the discounted cash flow approach.
Total invested capital.
o Each method of valuing a company or its business units evaluates the entire invested capital. These different values are compared to arrive at the final fair market value. It is often appropriate to weight the various implied values for total capital invested based on the relative effectiveness of each valuation method used for the analysis. Once the value of the total invested capital is determined, any claims to that value that have a greater right than the common stock are deducted to determine the fair market value of the common stock. These other claims include the fair market value of all debt, outstanding preferred stock, outstanding stock options and stock appreciation rights. Non-operating assets that were not previously valued must be accounted for and added to the total invested capital. These generally include cash and the fair market value of all non-business assets.
o The owner can expect the money to flow into the capital over an indefinite period of time. Although valuation models often use forecasts of future cash flows, it may be necessary to represent the value of a cash flow that can reasonably be expected to extend beyond the projection horizon. This value, known as terminal value, is often calculated by multiplying the fifth-year cash flow by a multiple. The selected multiples typically use the median multiple of total invested capital for comparable companies selected in the comparable public company analysis. The selected multiple may be lowered to reflect the company’s performance or size characteristics relative to comparable companies. This is quite similar to dividing the cash flow by the weighted average cost of capital and including a growth factor.
Question: Well, that’s all great. However, how will this help me buy a business?
Answer: You enter into a deal that allows the seller to receive an advance payment directly from cash flow when you take over the business. If that sounds too good to be true, here’s an example of its viability:
An aspiring young entrepreneurial couple, Sandy and Kevin, wanted to buy a successful restaurant and pastry shop in Northern Virginia. Although they were bright and energetic and had some experience in the food industry, they still lacked the ability—in the long run—to pay the $100,000 the seller wanted down to a total price of $500,000. (The restaurant had $1 million in annual sales, some of which came from a successful commercial venture that sold its freshly roasted coffee to local gourmet supermarkets and coffee shops.)
Fortunately, the seller agreed to cooperate and finance the $400,000 difference over five years at 10% interest. This often happens, especially with a good amount of persuasion. The couple’s problem, however, was to raise the remaining $100,000. Kevin’s parents strongly believed in the skill and determination of their son and daughter-in-law and decided to lend them $20,000 to pay back at their convenience. That certainly helped, but they still needed $80,000. To achieve this goal, a pair of CPAs developed a statement of cash flows for the first month of their clients’ new ownership. Their suppliers would not request any payment for one month, so Sandy and Kevin would not have these expenses. However, operational costs such as rent, payroll and utilities had to be considered.
After seeing the numbers from the financial analysis, Sandy and Kevin were confident that they could easily pull $80,000 from their business in four weeks. But the big question was: How could they convince the seller (who was expecting a $100,000 check at closing) to wait three to four weeks for his money?
Creativity, persuasion and seriousness were needed here. Together with the attorneys and their CPA, Sandy and Kevin worked out a plan that allowed the seller to hold the final sale documents for four weeks. During this period, the seller would be paid approximately $20,000 per week. If he missed payment, the seller would have the right to withdraw from the deal. The seller agreed to this proposal and gave Sandy and Kevin their American dream with no money of their own.
This example accounts for more than 80% of all acquisitions and takeovers. In the worst case, the seller may not cooperate; in which case you have to understand that he was probably never seriously interested in selling his business. It’s possible that during the negotiation process the seller was waiting to see how far you would go, which brings us to the next question.
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