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ment might make today s $250,000 price unreasonable at the end of the fth year All other conditions being equally attractive, removal of the seller s balloon entirely suggests that the purchase price could be quite good But to assume that average small businesses would, in ve short years, accumulate suf cient hard assets over the $60,000 that a bank might lend $147,851 against is ludicrous to say the least The balloon payment will come from the personal estate of the buyer, if it can be made at all
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What Then Might Be an Appropriate Purchase Price
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Let s assume three things for purposes of discussion: (a) the value of hard assets remains $60,000 at the end of the fth year; (b) a balloon payment will be necessary to get the deal completed; and (c) cash ow of $75,000 remained the same in forecasts to year ve Bank debt at purchase equaled $35,000 By the end of the fth year, this bank loan would have amortized down to $28,837, or would provide an equity position of just $6,163 assuming no additional principal payments are made Thus, total debt at the end of the fth year is $176,688 ($147,851 $28,837) Let s also make our example tight as a drum the buyer has no further assets to create additional equity for collateral (which re ects a whole lot of purchase situations) But he or she does have excess cash ows above a reasonable and market-comparable salary Reasonable salary ($35,000) you say Think on this a minute: How practical is it to expect that anyone could receive $35,000 per year on an investment of $50,000 (down payment) That s a 70% return per annum! Granted, you ve got to work for it, but you ve also purchased job insurance It s therefore practical to say that the salaried return is reasonable, at least in the context of money invested In this light we may decide that the $17,672 is excess for the purpose of valuation The buyer will need contingency and working capital reserves, so let s assign $5,672 for those annual purposes This leaves us with $12,000 per year, times ve years, or $60,000 of discretionary cash to assimilate into the equation of business value
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Cash Flow Free of Debt Less: Ownership Salary Cash Flow for Investment Return Less: Contingency/Working Capital Annual Discretionary Cash Times Five Years Accumulative End of Fifth Year $ 52,672 35,000 $ 17,672 5,672 $ 12,000 5 $ 60,000
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The question now becomes, What price could be paid initially such that this speci c buyer could purchase under the same terms outlined in the original proposal and still not worry about business interruption beyond the fth year
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Down Payment Amount Excess Earnings (5 years) Bank Debt Seller-Financed Debt (amount that will exhaust principal completely by the end of the fth year through payment of the same $1,485 monthly payment) Purchase Price
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In this conditionally rigid, hypothetical case example, the buyer could not pay more than $216,537 Thus the seller might have to seek a new buyer entirely or restructure payout conditions such that the excess earnings, when coupled with his or her nancing, build up closer to the anticipated price without a balloon Let s take a look at what happens in a seven-year scenario under the same frozen parameters
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Down Payment Amount Excess Earnings (7 years) Bank Debt Seller-Financed Debt (amount that will exhaust principal completely by the end of the seventh year by paying the same $1,485 monthly payment) Purchase Price
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In both examples, the buyer will have completely retired seller- nanced debt but will have lost the use of $12,000 cash ow per year times ve or seven years When this goes down in purchase-and-sale agreements, it usually shows up as additional annual principal payments, which, of course, makes calculations of rates of returns mighty hard And, of course,
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