For employees contemplating buying the business where they work, the first thing on their mind is the cost. However, before financing comes into play, legal fees rear their heads, and ongoing expenditures aren’t apparent until you’re in the thick of it, and a whole lot of financing comes into play.
Knowing what the real cost is allows uncertain buyers to either exit the process or feel empowered that it will work well for them. However, understanding the nuances and additional fees that accompany a business transition can mean the difference between a successful transition and an empty bank account before things even start.
Diving Into the Purchase Price
The first number people want to know when wondering about buying the boss’ business is what it’s worth. Typically, small to mid-sized businesses sell anywhere from two to six times their annual earnings, but this is situational based on industries and revenue stability. For example, a company makes $500,000 a year in profit; its selling price may be $1.5 million to $3 million.
But that’s just step one. The cost to acquire the appraisal, expected between $5,000 and $15,000 for a detailed and comprehensive business appraisal, costs. In addition, should the seller have a highly inflated view of their business, negotiations may run on for months (increasing professional fees). It’s not unheard of for sellers to hold onto their companies until they get what they want, stretching out costs along the way.
Evaluating Funding and Its Costs
The reality is, most employees don’t have enough money to just write a personal check for their boss’s business. Employee buyouts require financing, and therein lies where things get expensive.
When buying out the boss, you often need at least three sources of funding for 100% acquisition; otherwise, you’re personally liable for what’s not covered. Banks provide money, anywhere from 60% to 70% of the purchase price, assuming an employee can pay the current interest rates (small business acquisitions show 8% -11% currently). Therefore, on a purchase price of $2 million, if the employee finances $1.4 million, they’re looking at $140,000 to $175,000 in interest over five years (assuming interest rates do not rise).
More favorable SBA terms require mountains of paperwork but will cover 90% to 100% of a 10- to 25-year loan agreement; however, they require personal guarantees with assets on the hook if payments default. Closing costs alone can be between 3% and 5%. Seller financing where the current boss becomes the lender provides flexible terms but isn’t a good idea unless you aim to pay interest on top of your purchase price. It also opens up considerable liability when the company hits a rough patch but still requires payments to be made.
Additional Fees You May Not See Coming
One of the fastest fees buyers accrue that they weren’t expecting are legal and accounting costs. A reputable attorney will run between $15,000 and $40,000 for reviewing purchase agreements and contracts to ensure buyers aren’t assuming any liabilities from previous owners, even if this expenditure is necessary to save buyers from purchasing a business with unpaid debts or lawsuits.
Furthermore, accountants must sift through financial statements for years past to ensure what buyers think they’re getting is accurate. Costs range from $8,000 to $20,000 based on how messy things are. Complicating situations include tax ramifications or M&A (mergers & acquisitions) involving a sole proprietor or multiple entities when numbers increase exponentially.
Don’t forget about additional consultants who help structure the deal, business brokers or M&A specialists, to help avoid pitfalls charge either flat fees or percentages of total deals, with 5%-10% being customary for smaller businesses; a $2 million deal could translate into $100,000-$200,000 charged overhead.
Transitionary Costs
This is where people go wrong, they assume that after they’re handed the reins, everything will be smooth sailing financially. It never is. Transition period costs involve paying your boss if they stay on for guidance through the first few months; it involves retention bonuses for key employees staying through ownership change; it involves talking to existing customers and vendors who might need added attention/financial incentives to keep working with you.
Additionally, banks expect new owners to keep working capital independent of purchase price, three to six months worth of expenses is expected before they lend. A business paying $100,000 per month means lenders want assurance that there’s between $300,000-$600,000 in reserve cash, even if you won’t end up using it all down the line.
The Reality
Lastly, all these costs through financing and ancillary professionals seem one time, and they’re not. When all’s said and done and new owners take the helm, debt service becomes a monthly expense that didn’t exist before. On an annual basis where the business makes $500,000 and you owe $200,000 in loan payments, that doesn’t leave much cushion for mistakes or leaner quarters.
Insurance premiums always increase with different owners (underwriters assess risk differently), benefits packages might change relative to what employees might have taken for granted (extra benefits now at your expense), and all deficiencies that your boss didn’t want to upgrade now become your responsibility from day one.
Putting It All Together
As long as prospective employees understand that buying out their boss’s business is not simply about sticker price but realistic pricing in addition to estimates with additional fees they’ll be golden. Buying a business likely costs 20%-30% more than people expect; when it’s listed at $2 million, and by all means, it’s likely going to cost somewhere between $2.5-$2.8 million once finished.
Therefore, successful buyers create financial models that take every additional estimate into serious consideration, stress testing against worst case scenarios; gaining interest from other types of buyout employees/buyers who’ve gone through similar situations; understanding what they can take on for risk without stressing about one bad quarter taking everything down.
Buying your boss’ business is one of the most intensive financial commitments you’ll ever make, and it has nothing to do with what seems like a purchase price after all is said and done. Consideration means ensuring successful transitions do not become financially burdensome ones without an escape route in sight.