I would like to throw out two scenarios for discussion. Please offer your opinions, run the numbers if you like, and discuss your feelings on each scenario. This may seem a bit off-topic for a personal finance blog, but… … .. .. Hint hint – there may be a personal finance lesson to be learned here.
The discussion involves buying a company. It is not important what the company does, but I will provide you with some monetary details, and you tell me which scenario is preferable and why. If you feel there are details missing, please let me know. I can assure you the details will be overly simple and will not be as all-encompassing as if you were actually purchasing such a company. However, I believe I will provide enough to generate conversation.
I am very anxious to garner different opinions on the subject, and afterwards, I plan on posting another article with a wrap-up of the commentary and my opinion on the subject.
- You are a wealthy individual. How you got to be wealthy is unimportant, but you are a very savvy investor.
- The company you wish to buy is for sale at $36,000,000. This is the price you’ll have to pay – no negotiations.
- The company currently earns, before taxes and interest, $6,000,000 per year. The company currently has no debt and incurs no interest expense. The company’s prospects will not change when you buy it. Earnings, unless mentioned below in the particular scenarios, will remain the same. Expenses, unless mentioned below, will remain equal. Revenues and earnings will remain flat.
- You intend to purchase and hold the company and do not have an exit strategy – you do not currently plan to “flip” the business.
- The future worth of the company is undetermined. It will not be lower than your purchase price.
Now, the two purchase scenarios:
- You pay $36,000,000 in cash for the business
- The business therefore carries no debt from the purchase, and no debt of any other kind, save for the regular accounts payable and such.
- For argument’s sake, you had the $36,000,000 in cash lying around and did not have to personally borrow to come up with the money. You may also assume that you were able to comfortably afford this, and that this is not even close to “putting all of your eggs in one basket.”
- You therefore own 100% of the business free and clear.
- It continues to earn $6,000,000/yr
- You pay $36,000,000 for the business.
- The purchase price comes from the following sources:
- You put in $10,000,000 of your own money. Assume that you did not have to personally borrow to come up with the $10 million.
- You borrow $8,000,000 from the former owner. It’s a five year interest-only loan at 9% per annum, payable monthly at $60,000/month. At the end of 5 years, you will either draw up a new note or pay the former owner off in part or in whole. This is currently undetermined. The owner no longer has any equity in the business – just a loan held against it. Business sales often result in the former owners retaining a small piece of the company, or, in this case, the former owners give a loan to the new company – this is often done to consummate such a transaction, as the buyer gains tacit assurance that the company is on solid footing.
- You borrow $18,000,000 from a bank. It’s a 7 year level term loan, with an interest rate of 9% per annum. Business purchases are often financed with such a loan. Many times the interest rate is tied to an interest rate benchmark like the 1-month LIBOR + 3 or 4%, but for simplicity’s sake, we’ll just have a 9% non-floating interest rate. Your monthly payment contains the same amount of principal payoff each month, and in this case, you pay interest on the remaining principal. Therefore, interest in the first years is greater. Use this term loan analyzer to assist your calculations. This would leave you with a monthly principal payment of $214,286 and a first year interest bill on this loan of approximately $1.5 million.
- You therefore incur interest during the first year of ownership of $2.22 million, which lowers your first year profit to $3,780,000.
Which is the better deal, and why?
Which is the better deal, and why?