Guide to financing the purchase of
a business
- Glossary
There are a number
of terms that are familiar to many in our industry and these tend
to just trip off the tongue. However, some words and phrases can
seem a complete mystery - especially to first time buyers - and so
here are a few terms explained. Click on the appropriate word or
phrase and if you are still not clear, just let us know. If you
have any others you want explaining, we may even add them to the
glossary!
Whilst everybody knows the term
'Freehold', the concept of 'Leasehold' property may be
completely strange. What 'Leasehold' means is that the
freehold is owned by someone else (the Landlord, sometimes
called the 'Lessor') who grants a right to occupy the
premises for a specific period (the 'term') with specific
conditions of what the person with the right of occupation
(the 'tenant', or 'Lessee') must and must not do (the
'terms'), including how much and when the Landlord has to
be paid for the tenant's right to occupy the premises (the
'rent'), and when that rent can be changed ('review date')
- the document which sets out all this information is
called 'The Lease'.
Two further
points must also be considered about leases; firstly
whether or not the lease is 'assignable' - that is to say
that the tenant has the right to have the benefits of the
lease passed to someone else (such as the purchaser of the
business being conducted from the premises), provided they
are suitable to be tenants. Secondly, whether or not the
lease may be used as 'security' against a loan.
NOT ALL LEASES ARE RENEWABLE, NOT ALL
LEASES ARE ASSIGNABLE, AND NOT ALL LEASES MAY BE USED AS
SECURITY FOR A LOAN.
Landlords can be private individuals, local authorities, or property companies. In most cases the tenant will have the opportunity to renew the lease when the term of it expires, either by virtue of an option to renew contained within the old lease, or because the landlord wishes to continue to rent out the property, or because he is obliged to do so because of the provisions of the Landlord and Tenant Act, 1954.
In the majority of cases the tenant will have a right to renew his lease for a further period provided that the tenant has observed all the terms of the old lease. Your solicitor will advise you of the implications of the particular lease you are considering taking, as to whether or not you will have a clear right to renewal on expiration.
A term referring to something
tangible that the finance source can hold or have
charged to them during the period of the advance.
This can be freehold land or property,
leasehold property, valuables, etc. The value thereof
must be readily realizable and an allowance is often
made by discounting the value to ensure it can be sold
quickly to repay indebtedness.
In the event that the borrower
defaults on the loan, it is to this ‘primary security’
that the lender first looks to defray the outstanding
debt.
A lender will also require the
‘personal guarantees’ of the borrowers - thus they
remain responsible for any outstanding debt after
disposal of the prime security.
'External security' is that provided
additionally to the main or prime security being offered
(the business being purchased), such as a house or
shares.
Where there is insufficient security
in the value of the business that you are buying against
the loan that you need, a 'second charge' can be offered
on 'external security' - say a house - which already has
a mortgage on it. Whereas 'equity' refers to the
difference between the market value of the house and the
outstanding mortgage (the 'first charge'), usable equity
is considered to be 70 to 80% of the value of the
property (known as its 'forced sale value') less the
outstanding mortgage. Third charges will not normally be
considered suitable as additional security.
Thus a house might be worth £100,000
on the open market, but only have a forced sale value of
£75,000, if the first mortgage is for £50,000, then
equity in the house that could provide additional
security for a loan is £25,000.
This is an abbreviation for 'Stock at
Value' and often appears in advertisements or sales
particulars immediately after the price. It is
determined on the day of completion, usually by
independent stock valuers, at 'cost price'.
The purchase price is made up, therefore,
of either the freehold value or the value of the lease,
plus the value of the 'goodwill' of the business, plus
the value of the fixtures and fittings: these three
together will be the quoted 'asking price' in an
advertisement for the sale of the business, and in
addition you would buy the stock for whatever its value
is at cost on the day of completion.
Loans are normally expressed as a
percentage of the price excluding SAV - i.e. you will
normally be expected to find the balancing percentage of
the price plus SAV, plus purchase expenses, from your
own resources (usually without recourse to further
borrowing).
Accounts, by their very nature, are
historical and do not therefore necessarily reflect the
current performance of the business.
When initially viewing a business, try to
establish what the turnover and profitability is for a
recent trading period, say over the last 12 or 13 weeks
(unless the business is very seasonal), and be prepared
to accept either the Vendor's word or whatever proof has
been furnished (VAT records are usually an excellent
source for this information).
You can make further checks in due
course when you have had your offer accepted, and in
many cases the performance of the business will be
checked by an independent valuer, to determine precisely
the level of turnover and profitability, as part of the
process of the lender considering the loan application.
Clearing Banks often wish to see 3
years audited accounts, which can be a useful guide in
terms of trends, but hopeless for assessing the true
levels of current profitability.
Remember that it is the normal
convention in preparing accounts to show the turnover
and expenses with the VAT deducted - so the business'
'takings' (what passes through the till) will normally
be higher than its 'turnover' (the takings less the
VAT).
Gross profit is traditionally given
as the difference between the buying price of a product
(or all goods sold by the business) - i.e. what the
wholesaler or supplier charges, exclusive of VAT - and
the selling price, exclusive of VAT, expressed as a
percentage of that selling price.
However in some labour intensive
businesses (such as garage repair workshops and
hairdressers) wages are often included in the costs
prior to determining gross profit.
Thus goods bought for £10 plus VAT and
sold in a shop for £15 plus VAT will show a gross profit
of £5 - therefore the gross profit margin will be '£5
divided by £15 multiplied by 100 = 33.3%.
Gross profit margin should not be
confused with 'mark-up': in the example just given the
'mark-up' was £5 on a cost price of £10, therefore it is
calculated as '£5 divided by £10 multiplied by 100 =
50%'.
The net profit of a business is what
remains from the gross profit after deduction of the
operating expenses.
The operating expenses typically would include rates,
electricity, wages, accountancy, insurance, telephone,
motoring costs, etc.
Trading accounts will also show as expenses items which
are individual to the particular owner - such as
finance charges, taxation, depreciation, and owners
drawings.
Thus frequently reference is made to adjusted net
profit, which is the Net Profit that would have been
attained if these personal or individually variable
expenses had not been charged.
Please be aware that you are usually only entitled to
see the vendor's profit and loss account and not his
balance sheet unless you are buying the shares in a
limited company.
Goodwill is the element of the
purchase price that reflects the 'intangible value' of a
business.
One can put a specific
value on elements such as the freehold property, or a
lease, or the fittings, but it will be seen that these
elements alone do not make a business at all, let alone
one worth buying!
Goodwill is the value placed on the
fact that a business has been well established, has a
good reputation, regularly attracts a certain level of
trade, and maybe does so over limited hours, etc.
These are the items included in the
sale price and required to either display or store the
stock or otherwise perform the function of the business
(a counter, a till, a frozen food cabinet, an alarm
system, a barbers chair, the floor covering, a
computer, etc., depending on the trade).
An ‘inventory’ of what is included in the sale is
usually prepared as an integral part of the contractual
arrangement and unless specified by either the selling
agents or the vendor it is assumed that a prospective
purchaser will be taking over such items free of any
outstanding liability (HP, lease, etc.).
Items that are not the property of the business but are
on free or nominal loan from the supplier (often the
case with ice cream cabinets, greetings card stands and
tights/stocking displays, for example) should be clearly
identified.
As this suggests, it refers to the
ability of a business to repay or 'service' the
borrowing in addition to covering all its normal
expenses and generating an acceptable profit.
What is considered an 'acceptable profit' varies
according to the size and type of the business involved.
When considering borrowing, from the point of view of
both the lender and the borrower, it is essential that
there appears to be a clear ability to repay the
borrowing within the agreed timeframe, and this should
allow for the possibility of fluctuations in interest
rates and levels of trade.
