Business Contract Structure: Fill & Download for Free

There are four core variables which contribute to the return of a leveraged buyout:YieldEarnings GrowthMultiple Expansion (or Contraction)Leverage (i.e. Debt)Let's buy a typical business but only add/change one of these variables at a time.If you don't mind I will take a more normal business as an example rather than a hotel because hotels are a very rare breed of investments - part business part real-estate - with some very funky potential acquisition structures (e.g. "OpCo + PropCo" to separate the business from the property and borrow differently against each).Initial Set-UpYou, the investor, are given the opportunity to buy a widget manufacturer for $200m. The widget manufacturer has been operating for a number of years and produced earnings of $25m last year (let's keep things simple and say this is Earnings before Interest and Taxation, or "EBIT"). You are therefore being given the option to purchase the business at a multiple of 8x EBIT. From a cashflow perspective, let us assume that this manufacturer operates with very steady capex and working capital requirements, such that EBIT = Cashflow from Operations. Above and beyond that, let us assume that the corporation tax rate is 40%.1. YieldLet us start by assuming that the business isn't going to grow (variable #2 constant), that we will always be able to sell the business at a multiple of 8x EBIT (variable #3 constant) and that we are paying the entire price upfront (i.e. no variable #4, the entire acquisition is "equity funded"),Despite the lack of growth, debt etc, we would still make some money, because every year the business will be generating cash, which we can pay out as dividends - and this is our yield.In this example, every year we will generate $25m of cash from our operations, on which we pay 40% corporation tax, so $10m, leaving us with $15m.Our annual return will therefore be $15m divided by the $200m we paid for the business, or 7.5%. Not a great return but actually not too bad by itself either.2. Earnings GrowthLet us now look at our second variable, earnings growth. Let's assume that we believe the business can grow it's profits a bit every year. The growth is entirely from operations - you can either be growing your profits through additional sales growth every year, or by lowering your costs.This source of growth is considered the core value-add for private equity, and different private equity funds specialise at different aspects of operational improvement. Some funds specialise at super-charging revenue growth, whilst others are 'turnaround' experts who aggressively review the cost base in struggling businesses.In any case, let us assume this isn't a struggling business and we've figured out through our analysis that the business should be able to increase its profits by 7.5% per year.If we hold it for one year, what is our return?We will have generated $26.9m in earnings ($25m * 1.075) and $16.1m in after-tax cashflows. ($26.9*60%)We will then sell the business for 8x EBIT, or $215m (8 * $26.9m)Our return is therefore $215m + $16m = $231m divided by the $200m, for a ~15.5% return ("IRR"), or ~8.0% more than in the yield-only case.What about if we hold it for five years?Over 5 years (feel free to check in Excel), the cumulative cashflow yield would have been $94m, and our EBIT would have grown to $35.9mExiting at 8x EBIT would have generated $287m, plus the $94m from cashflow gets us to $381m on our $200m investment, also for a 15.5% IRR (the dividends we receive as we go increase our IRR)Note therefore that at this stage the maths on our return work out the same whether we'd done it for a 1-year hold, a 3-year hold or a 5-year hold.So what's our private equity return so far? ~15.5% consisting of 7.5% from yield and an extra 8.0% from earnings growth, and all of this without debt. Note: the way the maths work, the quick shortcut is to multiple the yield and growth returns together, so 1.075*1.075 = 1.155. The other relevant measure other than IRR is Multiple of Money (MoM) which is our total cash returned over total cash invested, in this case 1.9x MoM for a 5-year investmentNot a bad return but let's see how we can do better.3. Multiple Expansion or ContractionSo far we've been assuming we always exit our investment at 8x EBIT. However, like all investors, we know that picking the right time to buy and the right time to sell can really help or hinder our investment.Let's assume however that we held onto this business for 5 years, so generated $94m in dividends over that time and created a business with profits of $36m.What if other investors suddenly realised what a great business we had? Or if we'd managed to grow the business into more exciting/sustainable products? Perhaps people would now be willing to pay more than 8x EBIT for it, maybe even 10x...How would 10x EBIT look?Exit value of $359m (10x $35.9m) plus cashflows of $94m equal $453m, over our original investment of $200m gives an IRR of ~20% and MoM of 2.3xPause and Summarize so FarWe purchased a business for $200m at 8x EBIT entirely with our own cash, and grew its profits by 7.5% per year for 5 years. We made the business more valuable and other investors were willing to buy it from us at 10x EBIT.We generated a great return without using any debt: we got an IRR of 20%, and multiplied our investment by 2.3x.If we roughly apportion the sources of value creation so far, they came ~35% from Yield, ~35% from Growth, and ~30% from Multiple Expansion.4. LeverageNow let us indeed bring debt into the equation. With respect to your specific example, I think it's misleading because I've never heard of an LBO with 100% debt funding! More likely, this $200m widget manufacturer would have been bought with ~60% debt (so lets say $120m), with the difference of $80m being paid up-front by the private equity fund as equity. You never get to buy a business without putting some of your own money up!So we borrowed $120m from various lenders. These lenders are taking quite a big risk, because it's a big loan that is secured only by the underlying business (quite like a mortgage). As a result, they will charge us a very high interest rate, which net of any tax impact costs us 10% or $12m per year.How does this affect our 5-year return?Instead of using the $94m of cashflow to pay ourselves dividends, we are now using it to pay 5 years of interest at $60m (5* $12m), plus we further pay down the rest of the debt so there's only $86m left after 5 years ($120m-$34m)We still sell the business for 10x EBIT or $359m, we use that money to partly pay back the remaining debt of $86m and are left with $273m ($359m-$86m)Our IRR looks a lot better (~28%) and our MoM reaches 3.4x ($273m/$80m invested)It's important to note that the debt boosted our return, but the actual act of paying it down wasn't where the value was created - because we can only pay down debt with cashflows, and we could have paid ourselves those cashflows as dividends anyways if we hadn't borrowed to buy the business.If we roughly apportion the sources of value creation so far based on IRRs, they now came ~25% from Yield, ~25% from Growth, ~20% from Multiple Expansion and ~30% from Leverage.Additional Discussion on LeverageWhy is it that the leverage is boosting our return so much? If we didn't use debt, we would have gotten at ~20% annual return, but with it we get ~28%.Let me perhaps frame it in a clear way: you as the investor had the opportunity to buy a business that would give you a 20% annual return. In the meantime, someone offered you a loan at 10% for up to 60% of the price.Of course you would take the loan if you were sure about the 20%! For every $10m you borrowed and invested, you would have gotten $2m in returns but only paid out $1m in interest - gaining $1m. So you are capturing the gap between the 20% underlying return and the 10% interest rate.Does this always work? No. Because sometimes your underlying return is lower than the cost of debt:Let's say we bought the business but it didn't grow and we didn't get any multiple expansionAfter 5 years, we would have generated 5 * $15m in cashflows from the business, less 5 * $12m in interest repayments - so $15m netOur debt would therefore stand at $120m-$15m = $105mWe would sell the business for $200m, repay the remaining $105m of debt and get $95m back on our $80m investmentThis is an IRR of 3.5% and a MoM of 1.2x - much lower than the 7.5%/1.4x we would have gotten if we hadn't used debtThis is an example of buying a business with an underlying return of 7.5% but paying for it with debt costing you 10% - you are losing the 2.5% gap for every $1m of debt you useHope that helps and answers you question!

Firstly, you should never buy a cafe or restaurant without professional help in the form of legal and accounting advice. The price you pay for these services will often be offset by savings in the negotiations or they will save you a fortune from making the wrong decision made on wrong assumptions. You might even look to engage a knowledgeable business broker in this field to help you or an experienced cafe/restaurant owner who can spot the problems that your rose-tinted glasses will never see.So that’s step 1 in the due diligence process - get professional and experienced help.I have both purchased and sold cafes and restaurants and here are the areas that the professional and experienced help looked at in those transactions:Verify the turnover/takings: The price you are paying for the business is pretty much determined by the volume of turnover that the vendor is saying they are achieving. Your accountant will normally ask for prior year’s tax returns to verify this turnover (although everyone knows that this will be understated). You might also ask for a two week due diligence period, working in the business prior to settlement to verify the turnover. Your experienced and knowledgeable help will be looking at things like coffee bean purchases, staffing costs and seating/covers because these are all good indicators of total turnover.[1] For security, your solicitor may include a performance clause in the contract that specifies the minimum takings of the business over an appropriate period leading up to settlementBe clear about what you are buying: This is a 101 issue for solicitors who will advise you of the pitfalls in buying the business vs buying the assets of the business. Buying the assets of the business is less riskier than buying the business because you will not be taking on the obligations and liabilities of the business. However, sometimes you need to buy the business because certain value may be tied to it like licenses and agreements. Either way, make sure that your solicitor is fully engaged in this process.Ensure that the assets are unencumbered: Make sure that the assets that you are buying are free of encumbrances. i.e. that others like financiers do not actually have claims over them. Again your solicitor will be across this issue and will be asking for verification of ownership or secure some form of guarantees from the sellers.Ensure that the assets are in good working order and are fit for purpose: This is where your experienced restaurateur or cafe owner comes in handy. They will know about the capacity of the equipment, its maintenance status, the tell-tale signs of impending expensive repair and it’s brand/quality to help you understand what you are buying and whether you are paying fair market value. See User-12828854714828252077’s comment [2] .Determine if you are taking over the staffing obligation: The goodwill that you are invariably paying for, includes the relationship that the existing customer base has with the business. This relationship is typically built on the existing staff but with the change of ownership, will you be re-employing the existing staff under new contracts, at least in the short term? If so, then you will need to check the terms and conditions of their current employment as part of the due diligence process. Make sure the outgoing owner pays out all the outstanding wages and benefits (i.e. holiday pay, superannuation obligations, long service leave)Set the makeup of the purchase price: Typical cafe/restaurant sales will involve two key components: (1) the value of the assets/business being purchased and (2) the value of the goodwill (the difference between the purchase price and the value of the assets). Your accountant will advise you of the tax implications of this makeup which usually tries to maximize the value of the assets/business for the buyer because these values can be expensed (depreciated) against future earnings whereas goodwill can not.[3] Unfortunately the seller’s accountant will be advising their client to do the opposite. So this is both a due diligence and a negotiation issue.Ensure the business has current food and liquor licencing certificates and they have been transferred to you: In most jurisdictions a cafe/restaurants needs food safety certificate to operate. You may be able transfer the existing licence or you may have to obtain one for your new operations. Either way it is a critical action on the list of due diligence. If there is a liquor licence attached to the premises, make sure it is transferable and available to you on your first trading day. This can take time so make sure it is addressed well before the proposed settlement date. Your solicitor will usually make the transfer of important existing contracts and licences, a key condition of the sale.Conduct a stocktake and determine values: You will typically be buying the stock on your first day of trading. So you will need to determine the process, the goods that you don’t want to buy (you don’t have to buy everything) and how the goods will be valued. An estimate of the value should be provided during the negotiation period.Check the key items in the contract of sale: Your solicitor will want to ensure that any representations made by the seller are guaranteed by the seller and incorporated as a condition in the contract. Some monies from the sale may be set aside in a trust account as a guarantee of the seller’s performance post-sale. You may also look to insert a restraint of trade clause in the sale contract to restrict the previous owner from operating a similar business within a certain distance for a number of years. Also make sure that business names and social media profiles for the business are appropriately transferred or agreed to be transferred. These issues are well covered by a Victorian Government’s business sale contract checklist.[4]Check out the lease terms: The vast majority of cafe/restaurant sales will not be freehold sales (buying the business + the premises) but will in fact be just buying the business within a leased premises. The lease is the right of tenure for your business and there are critical parts to the lease agreement that can have significant impact on the sale negotiations and your future profitability. You will need an experienced solicitor to help you identify these critical parts and advise you accordingly. Based on my experience, here are the critical parts that I would be looking at to either make sure my tenure was secure or to use in the negotiation process.Lease term: How much more time has this lease got to run in the current term and what is available under future option periods? The longer the term the better.Bond: How much is the bond (a lease guarantee which is usually 3–6 months rent value) on the lease agreement and how is it to be dealt with in the sale? This can have a significant impact on your cashflow.Assignment right: Does the lease agreement give the existing owner the right to assign the lease to you? Without it, the sale can’t proceed without renegotiating a new lease with the landlord.Current rent and rent increases: Is the current rent the amount that the seller disclosed to you and when is the next rent review date and what is the structure and % for increasing the rent? Look for the big increase in rent that may have been negotiated at the start of the current business.Trading times: What are the allowable trading times under the lease? Make sure you can trade the hours you want.Permitted Use: What does the lease say about the permitted use of the premises? Does it allow sub-leasing? Make sure you can do the things you want with the business.Outgoings: What is the amount of the outgoings? (your business’s contribution to the owners building insurance, rates and building maintenance). This amount is above what you pay for the rent.Breaches: Are there any current or past breaches under the lease agreement?Other issues: The suitability and soundness of the premises, any council plans for road changes or new shopping developments in the area, the premises have meet hygiene inspections and safety regulations as evidence by certifications and notices.These areas give you a general view of the due diligence that was undertaken in the cafe/restaurant businesses that I traded but I emphasis the point again that it is best to outsource the due diligence process to professional and experienced people because every sale transaction is different and the smallest issue overlooked or unaddressed may have major ramifications in the future.Footnotes[1] Peter Baskerville's answer to What valuation multiples/techniques should I used to determine the valuation of an existing coffee shop for sale?[2] https://www.quora.com/What-due-diligence-is-required-when-buying-a-cafe-or-restaurant/answer/Peter-Baskerville/comment/50521884[3] Guidelines for allocating the purchase price of a business - Hall & Wilcox[4] Checklist: Buying a business, existing or estalished

I was grabbing a coffee with a friend the other day and in the coffee shop, we got into a conversation with a gentleman who started telling us about his food truck. He was going on about how they originally took a $50k loan to get the business going, and how he was spending 16 hours a day on the business. I was supportive and respectful, but not how I look to go about my businesses. 16 hours a day at the beginning, maybe 1 hour a day once it’s launched.Brick and mortar businesses are going out of style. Brick and mortar businesses are expensive as well ($50k for a food truck with no guarantee of success!!) If you want to make it big, you have to leverage your network and the reach of the internet.I’ll give you a few business ideas that cost less than $200 to start. Most are built around creating content and building an audience. Content creation is a great way to start a business. Essentially, build an audience, then monetize. I will also list a few others.Blog (less than $50 for domain name and 12 months of hosting fees)Start writing unique content on a specific niche and you will build an audience. Over time, you can add ads, affiliate links, products, coaching courses, etc. to your blog. Since you already have an audience, they will be open to buying.Social Media Sites: Twitter, Instagram, YouTube, Facebook (free)Why not utilize a platform that already has millions of users? You can create an account on any of these platforms and start building a business this way.I watch a lot of YouTube videos and it’s crazy how people can make a living off creating videos.One downside of these platforms is if they change their algorithm or pay-out structure, then you may lose out on views, ad revenue, etc.Consulting or Coaching (Free, but will take time to build a client book and reputation)Are you an expert in a certain field? You can contract for and consult clients for a solid hourly wage. It’s a fun job and if you can communicate well, it would be a solid role for you.Digital Product Creation (think e-book or how-to-guide, Free)Creating a e-book on an area you are passionate about and sell it for a few bucks. The only time you spend is upfront, after that, it’s passive income.It’s a great strategy these days to leverage the internet’s wide reach. There is so much money in the world right now… we just need to go and get it.