Thursday, June 7, 2007

Question for discussion - Buy a company with cash or with debt?

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.


THE DETAILS:

  • 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:

Scenario #1:

  • 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

Scenario #2:
  • 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?

17 comments:

broknowrchlatr said...

I think this discussion can be simplified quite a bit. The cost of the business and the annual return is irrellevent (as long it is returning 10%+)

Regardless of the specific terms of the loans, the fact is that you are paying 9% on any outstanding balance. As such, it can be inferred that you are making 9%, garaunteed, on funds paid against the loan. I would think that any investor would appreciate a gauranteed return of 9%. So, to me, option 1 is the better choice. You can then sit on your 16.7% annual pre-tax returns on your investment.

To pick option #2, you must be confident that any other investment would yield greater than a 9% return. Even if $36 million is all the money you had, you can invest all of the returns more aggressively. After about 5 years, you'll have $36MM in the business earning 16.7% and another $36MM in other investments; quite an enviable position.

Q said...

broknowrchlatr,

I believe you have correctly calculated the return earned via option #1. What do you calculate as the return for option #2?

plonkee said...

I get a 37.8% return with option 2, since I only invested $10m, I am then free to make other investments with the remaining $26m. Unless of course I've calculated it wrong.

This is more than twice as good. Key words are guaranteed return and exit strategy, though.

Mike Perry said...

A very wealthy man told me that there are three requirements to be welathy:
1. Smile
2. Have a suntan
3. Use other peoples' money

Mike.

Q said...

plonkee,

you nailed it. as far as guaranteed return and exit strategy, definitely two things NOT taken into consideration with this example. Running a business is much more complex than a simple spreadsheet.

but the calculation that you and broknowrichlatr did is the very calculation that wealthy folks and venture capitalists do when studying deals.

Q said...

mike perry,

the tan is the most important part! I have to remain pale white to avoid the skin cancer, but perhaps I'll still be wealthy someday. :)

Moneymonk said...

In general, this is why some people prefer to finance something than to pay cash. Some do indeed have the money but they do not want to be cash poor.

Therefore they finance it and keep their cash.

These scenarios are all about emotions. The people that pay cash get more of a security emotions. Those that finance try to find a way to buy time to invest in more avenues. Some take risks and some are more careful

Q said...

moneymonk,

Such decisions are about emotions if you let emotions in the game. Perhaps correct financial decisions can be made with the clarity you'll have if you can keep your emotions out of the decision-making process.

Dough Roller said...

I would pick option #2. To make my calculations, I had to make an assumption about taxes, because I base my decision on after-tax returns. I assumed a total tax rate of 40% (~34% federal + state), although it could be higher or lower depending on where the company is located. In option #1, the after-tax return each years is $3.6 million ($6 million - 40%). Thus, the total return over 8 years (when the loan with the former owner is due) would be $28,800,000 ($3.6M x 8).

The after-tax return in option two changes each year, because the amount of interest paid to the bank decreases as the loan balance goes down. Here are my rough calculations on the after-tax return for option #2 in years 1 through 8:

Year 1: $2.243M
Year 2: $2.352M
Year 3: $2.471M
Year 4: $2.601M
Year 5: $2.743M
Year 6: $2.899M
Year 7: $3.070M
Year 8: $3.168M

The total 8 Year Return on option #2, assuming we pay the $8M balloon payment to the prior owner, would be $13,547,000. Thus, with option 1 after 8 years, the total return would be 80% ($28.8M / $36M) while the total return on option #2 would be 135% ($13.547M / $10M). Add to that the lost opportunity cost from option #1 by using $26M of our own money, and option #2 looks even better.

DR

KMull said...

My answer is: it depends.

Can I redeploy the rest of the cash in a better investment? If so, borrow.

GeekMan said...

An important piece of information is missing from the example, how much do you get as take home? The example only states that the business earns $6MM, but do you as owner get to keep all that money or would you only get a portion of that so the rest is re-invested into the company? Let's not forget that no owner of a company that wants to keep that company growing and profitable would keep all the profits for him/her self.

However, even without that information taken into account, option #2 is the better option for buying a company UNLESS your plan was to immediately sell off the company (in part or in whole) for an immediate profit. Mike is absolutely correct that in business it is always best to use other people's money.

Q said...

dough roller,

Regarding your option 2 calculations, what about the equity gained in the company by paying off the bank loan? Can that, or should that be incorporated into a calculation of your total return?

KMC said...

This is more of a tax question. There are definite advantages to using debt (though I forget exactly how to calculate it - business school was a couple of years ago).
If I remember right, most businesses use a mix of debt and equity because interest payments come off the top line before tax.

Dough Roller said...

Q, your response to my comment is a good. I should have considered principal repayment. I also think I shouldn't have assumed that the $8M would be repaid after 8 years, so in the end, the result would have been about the same. Having said that, I think there is an easier way to assess the options. The cost of debt here is equal to interest rate * (1 - tax rate), or 9% * (1 - .4), which equals 5.4%. So isn't the question whether the owner can put the $26M in capital in option 2 to work in another investment that returns more than 5.4%? Give that that equals about the risk free rate, I still think option 2 is preferable.

DR

TMAC said...

This is a pretty neat question. I would go with option two because you have less "skin in the game" and are free to make other investments with the money.

Mr. Cheap said...

Very interesting post / challenge!

At first I was leaning towards the first choice, since as broknowrchlatr mentions, you'd need to be earning 9% or more in another investment to make it worthwhile to hold back the cash.

However, if you have the option to participate in this deal with a 37.8% return, its probably VERY likely you'll have other opportunities to invest for more then 9%.

I definitely like the idea of "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." I've wanted to do this when/if I buy an apartment complex, for exactly the same reason, so the person has more incentive to be upfront about the state of the building and the earnings.

Glad to hear its common practice! :-)

QUALITY STOCKS UNDER 5 DOLLARS said...

Good question.