- March 16, 2016
By Stephen Mariani
A complete and comprehensive memorandum is not only a great advertising tool for buyers but also lenders will use much of the information included in them for their internal write ups. Countless times we are asked about small print items in the memorandum that we didn’t even know were there.
It’s typically that the first item a potential buyer receives after signing an NDA with the listing broker is a confidential memorandum. The next thing they do with it is share that with their trusted advisor and/or lending professional for a second opinion and validation of their research. Below are the initial items that both will review and depend upon when considering an offer on your listing.
First they look at the SDE or cash flow of the business to determine if it truly fits their requirements and is able to produce an acceptable level of income. This is where they typically ask about the “addbacks” and the validity of each one. Going item by item to better understand what is being presented as “seller discretionary” expenses. Some potential buyers will begin to lose interest at this point if they become overwhelmed by the amount of add backs used to meet their required income. The “unwritten” rule of thumb amongst most lenders is that if over 20% of the SDE is being derived by addbacks then this may be of concern. Keep in mind that items like depreciation, interest and owners salary and not really looked at by lenders as addbacks as they are basically included in almost every financing opportunity a lender considers. The biggest concerns come when they are multiple salary addbacks (other than owner), many cell phones, auto expenses, etc. that compile the majority of SDE. I won’t go into much more detail on addbacks as that is another writing entirely. You get the idea.
The second area a potential buyer explores is usually the current management and operational structure of the business. They want to understand what it takes to manage this business and who is doing which job today. Will there be employee concerns in this area after the transaction closes and will employees be difficult to replace if they do leave. The buyer also tries to understand, in these earlier stages, where they fit in and where their skillset is of greatest value. If the company has been lacking in sales and marketing and this particular buyer has that strength then in their mind they see all upside and this usually increases their level of interest. This is a big step toward considering an offer on this business.
At this point they understand the cash flow and have determined where they can be of value to the company so what do they read next in your memorandum? The current customer base and competition is the next area we usually see them explore. They look for customer concentration concerns and competition in the market. From a lending perspective we can understand that an older, more established business might gravitate to one or more customers that have increased their purchases over the last many years. This may lead to a customer concentration concern but, if for example, one of your customers is GM and they have increased their orders over the last 10 years, is that truly a bad thing? Although GM has now become 45% of their sales, it shows the level of quality and customer service this selling company provides. I interpret that as a natural event and present it as such with the lenders we work with. I explain that any quality company would do the same and turning GM work down would be a poor management decision. Maybe the company is guilty of not diversifying, but as the principals grow older this tends to be less of a concern to them, completely understandable and explainable. By explaining the lenders view on the customers it usually brings the concern to a minimum with a potential buyer and keeps them moving forward.
Competition can be understood 2 different and opposite ways. I have actually had a lender decline a loan due to the LACK of competition. Their concern was that the town only had one of these type stores and that it was not a viable business model, they went on to say that they would have preferred 4 or 5 competing stores in the market that would have shown sustainability. I prefer to present a business that owns market share and even a specialized niche’, but again, this will depend on a lenders perspective and understanding. The buyer is usually looking for an opportunity to capitalize on their competition and your memorandum should disclose potential growth avenues. A few weaknesses of the competition will confirm the opportunity to a buyer.
Detail some growth and expansion possibilities moving forward in addition to the competition described above. Providing just enough information to allow the buyer to understand 2 or 3 growth opportunities is a must to include. Don’t go into too much detail as they sometimes interpret that as a sales pitch (which is really what the entire memorandum is) but leading them with possibilities allows them to explore growth potential in a direction you may want. If a buyer feels the avenue for growth is there it leads them to believe the future is in their hands and after all, isn’t it?
The goal of every memorandum is to leave the reader with a feeling that they would be missing an opportunity if they don’t act now. Effort upfront will pay big dividends in the end.
AskDiamond@easysba.com is always available for specific questions regarding this or other SBA rules.