What Is It?
When selling your business--whether to a family member, a key employee, or a third party--you effectively become a lender to the business unless the sale is entirely for cash. Most ownership transfers are structured so that you exchange stock for an interest-bearing installment note, or you receive payments through a supplemental pension plan funded from future business earnings. You can also receive payments under a noncompetition agreement, under a post-sale consulting contract, or from royalty fees. Whenever you depend on receiving future payments, you run the risk of not collecting those funds. However, there are ways to secure the income stream you will depend on in the future. One approach is to establish cash flow/balance sheet requirements or key ratios for the business.
Cash Flow/Balance Sheet Requirements
Cash Flow Requirements
Cash flow is generally defined as earnings before interest, taxes, and depreciation (EBITD). You should consider requiring the business to maintain enough cash to cover EBITD at least 1.0 time. For greater security, you can raise the factor (e.g., some banks and other lenders require 1.25 to 1.5 times EBITD). If the borrower falls below the agreed-upon coverage requirement, it triggers default. For example, if Avid Enterprises' average annual EBITD is $450,000, Avid will need to increase its cash flow to $562,500 to maintain coverage at 1.25 times EBITD.
Balance Sheet Requirements
You can also require the business to maintain certain key balance sheet ratios. These can include the current ratio, the quick ratio, and the debt-to-equity ratio. These ratios should be measured periodically and compared to industry standards. You should generally want key financial ratios to meet or exceed industry standards.
Caution: Understanding and evaluating financial ratios can be a difficult skill to master. You can't go just by the numbers. You need to exercise good business judgment in understanding what they're telling you.
Current ratio--The current ratio (total current assets divided by total current liabilities) is a liquidity ratio that measures the ability of the business to meet its current debts. For example, Avid Enterprises would calculate its current ratio as follows:
Current Ratio = Current Assets / Current Liabilities
Current Ratio = $800,000 / $575,000 = 1.39 times
Compared to an industry-standard current ratio of 2.3 times, Avid's current ratio of 1.39 times indicates that its safety net for meeting short-term obligations is relatively low. This could signal a liquidity problem. However, since the ratio is greater than 1.0, the situation could be well in hand. As with all ratio analysis, Avid must exercise care in understanding and evaluating this ratio.
Quick ratio--The quick ratio, also called the acid-test ratio, is calculated as the sum of cash plus marketable securities plus net accounts receivable, all divided by current liabilities. The quick ratio is an even more stringent measure than the current ratio of the business's ability to meet its current debts. A satisfactory current ratio, for example, may not disclose that a portion of current assets is tied up in slow-moving inventories. Eliminating the cost of inventories, along with prepaid expenses, provides better information for the short-term creditor. For example, Avid Enterprises' quick ratio is calculated as follows:
Quick Ratio = Cash + Marketable Securities + Net Receivables / Current Liabilities
Quick Ratio = $490,000 / $575,000 = 0.85 times
Avid's quick ratio of 0.85 times is low compared to the industry standard of 1.2 times. This indicates that Avid could have problems meeting its short-term debt obligations unless it can convert long-term assets to current assets, obtain additional financing, or boost its earnings.
Debt-to-equity ratio--The debt-to-equity ratio is calculated as total debt divided by total equity. Total debt includes both current liabilities as well as long-term debt. This ratio, called a coverage ratio, tells creditors how well-protected they are if the company becomes insolvent. Creditors prefer a low debt-to-equity ratio. This ratio has a strong effect on the company's ability to obtain additional financing.
For example, Avid's debt-to-equity ratio is as follows:
Debt-to-Equity Ratio = Total Debt / Total Equity
Debt-to-Equity Ratio = $1,300,000 / $2,250,000 = 58%
Compared to the industry standard of 38 percent, Avid is a highly leveraged company and could have difficulty obtaining additional debt financing.
When Can It Be Used?
You can set cash flow/balance sheet requirements to secure your future income stream when you're transferring ownership of a company through a deferred payment plan, such as an installment note or a supplemental pension plan. These financial standards can also apply to payments received under a noncompetition agreement, under a post-sale consulting contract, or from royalty fees.
By establishing cash flow/balance sheet requirements, you set financial standards that can strengthen your personal financial security during the deferred payment period.
You need to balance your concern for personal financial security during the deferred payment period with the objective of perpetuating a competitive business. You don't want to handicap the business with excessive cash requirements so it can't carry on. You only want to ensure that if the business starts to fail, you get it back while it still retains value that you can sell to another buyer.
How to Do It
Have the business's accountants determine an average historical cash flow. Even if the business is in a cyclical industry, the historical average can take this into account. To avoid having a low seasonal cash flow accidentally trigger a default, you can periodically test the coverage and set the default as four or more quarters below the norm.
You can help the buyer strengthen the business's cash flow position by structuring more of your payment as a tax-deductible expense, such as a noncompetition agreement or a post-sale consulting contract, rather than as a long-term debt. If an existing lender requires specific debt-to-equity ratios to be maintained, along with current or quick ratios, write these requirements into your sales contract. The remedies for default or cross-default are different depending on the structure of the deal.
- For an installment note, a breach could cause foreclosure on collateral.
Caution: A current or future lender will probably insist on subordination of an installment note.
- For a supplemental pension plan, a breach could trigger a call-down provision through the rabbi trust, if it was funded. Even an unfunded trust could include a "springing" provision that requires funds to be deposited.
- For a noncompetition agreement, a breach of cash flow/balance sheet requirements could void the agreement without requiring you to pay a penalty to the buyer.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that specializes in transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.
The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.