Succeeding in Your Business: Protect yourself when buying a business during these tough times

“My wife and I are looking to buy a small business.

“We were looking for a very specific type of business, but we’re a little nervous because there’s a good chance the business model will be affected by COVID-19 and any future economic shutdowns.

“We’ve found a fairly healthy business in our area. The seller is willing to sell, and acknowledges our concerns, but insists that the purchase price be based on his annual gross sales for the past year. While that would be fair in a normal environment, we’re concerned that sales for the next couple of years will be significantly lower because of the impact of COVID-19 and related government shutdowns.

“No one can predict the future, and we don’t want to deny this seller the opportunity to get a return on the last 10 years he has spent building this business. But we don’t want to buy at the ‘top of the market’ if this business model is destined to collapse in the near future.”

Normally, the purchase price of a business is based on the business’ past performance. Usually, it’s a multiple of the seller’s average gross sales or pretax earnings over a number of years. The first thing you should do is look at this seller’s gross sales over the past five years (the “go-go” years of 2018 and 2019 probably distorted his results, so you need to look back over a longer period). Do a quick arithmetic average of his gross sales over the five-year period. If the average is significantly lower than his gross sales last year, then the purchase price is not reasonable, COVID-19 or not.

Assuming his quoted purchase price is reasonable, you will need to factor in the risk of another government shutdown. It will be almost impossible to quantify that risk, so the best you can do is make the seller share that risk with you.

Under no circumstances should you pay for this business in all cash. You should insist that the seller accept at least 25 percent to 30 percent of the purchase price in monthly installments over the next two to three years, with interest at a commercial rate (currently about 5 percent to 6 percent per annum).

If the seller is agreeable to that, then you need to limit your downside risk. The most common way to do that is to put a “ratchet clause” in the contract of sale allowing you to reduce the portion of the purchase price you pay over time in the event COVID-19 — or, indeed, any change that is beyond your control (such as racial unrest in your community) — reduces your gross sales or squeezes your profits.

First, you would figure out what the seller’s average gross sales were for the past three to five years. Then, you and the seller would agree that if your average gross sales fall below 90 percent of that monthly average for three consecutive “rolling” months due to circumstances “beyond your reasonable control,” you can reduce the balance due to the seller dollar for dollar by the amount of the shortfall each month for as long as the situation continues. You are still stuck with a potentially losing business, but the seller is sharing the pain with you by seeing the outstanding portion of his purchase price get lower and lower each month.

What happens, though, if the business suffers a revenue loss due to your own incompetence in running the business? Reducing the purchase price dollar for dollar in that situation allows you to profit from your own lack of business skills, which the seller won’t tolerate.

As Shakespeare would say, “Ay, there’s the rub.” Your attorney will need to draft the ratchet clause very carefully and provide for informal but binding third-party mediation if there’s a dispute down the road over whether the business downturn is your fault or the government’s.

Another but less common way to protect yourself against future risk is to insist that the seller guarantee your monthly revenue for a period of time after the business changes hands (usually one year). You would hold back a portion of the purchase price (10 percent to 20 percent is customary) and deposit it in a no-interest escrow account. Then, if your actual monthly gross sales during the next year fall below the agreed-upon threshold, you simply withdraw the shortfall amount from the escrow deposit. At the end of the one-year period, the seller gets whatever is left in the account.

The seller won’t be wild about either option, but if he has a brain, he probably recognizes the risk and will accept the fact that it may be a lot harder to sell this business two or three years from now — when the full impact of the healthcare law changes are known — than it is today.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.” 

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