Download CFI-Letterhead Template

PURCHASE OF BUSINESS FORM
This is a Microsoft Word document to be filled out on your computer by both you and your spouse. Do not print
and fill out by hand. Various tables will have to be expanded to accommodate your additional information.
This form has been designed for two purposes:
 To help evaluate the purchase decision, but it can also be used to evaluate an existing holding.
 To see what affect such a purchase will have on your Retirement Update Letter.
This document may seem overwhelming. If so, we will be happy to help you complete the form.
Client Name:
Spouse Name:
Date:
STEP 1 – POINTS TO CONSIDER
For areas of concern or interest, place an “X” in the adjacent box
Planning – Having a deep bench of advisors is critical. In addition to discussing this idea with friends and
family, have meetings been set up with operations experts in the field? Can someone mentor if have no
experience?
Planning – Has a meeting been scheduled with a banker to discuss financing if required?
Planning – Has a meeting been scheduled with an accountant to discuss tax issues?
Planning – Knowing how to terminate a venture is as important as creating the initial business plans. Is an
exit strategy in place if termination in near future is required for unforeseen reasons, such as a buy-sell
agreement?
Planning – How will business purchase impact retirement projections?
Resources – Is financing available? If a balloon loan is required, what are the potential risks when this loan
comes due?
Resources – In the event of temporary illness, is there someone able to run the business? Is there a business
continuity plan?
Resources – Is capital sufficient that months of slow sales will not cause operations to cease? How many
months of cash are on hand to cover overhead?
Risk – If the enterprise fails, will the losses be limited strictly to business assets or do creditors have the
ability to access personal assets?
Risk – Has a meeting been scheduled with the insurance agent to discuss insurance requirements?
Risk – Has a meeting been scheduled with an attorney to discuss the advantages of establishing a Limited
Liability Company (LLC)?
Additional Points or Comments:
Page 2 of 6
STEP 2 – CLARIFY THE RATE OF RETURN (ROR)
There are two ways to evaluate Rates of Return (ROR):
1. Rate of return specific to the business only, which uses the Return on Asset (ROA) method.
2. Rate of return for the investor, which uses the Return on Equity (ROE) method.
How do these methods differ? While both methods start out with the rate of return intrinsic for the business
itself, the Return on Equity (ROE) method has the additional dimension of investor debt. Surprisingly, the
addition of debt can cause widely divergent results between the two methods. An example will help clarify this
point. Assume:
 The business costs $1,000,000 to purchase.
 Projected positive net income excluding interest expense of 10% ($100,000) annually.
 Projected unrealized capital appreciation of the business of 4% ($40,000) annually.
 A bank loan of $600,000 at 8% ($48,000) interest.
Using the information above, the Rates of Return (ROR) using the two methods are:
 Return on business only using Return on Asset (ROA) method:
($100,000 + $40,000) / $1,000,000 = 14%
 Return to investor using Return on Equity (ROE) method:
($100,000 + $40,000 - $48,000) / ($1,000,000 - $600,000) = 23%
These results indicate that the expected rate of return inherent to the business itself as revealed by the Return on
Asset (ROA) method can almost be doubled if debt is introduced, as shown through the Return on Equity
(ROE) method. Keep in mind that debt is a two edge sword. Debt has in the past caused Return on Equity
(ROE) rates to drop below Return on Asset (ROA) rates, go negative, and even cause the business to fail. These
events have occurred in the past, and can happen again:
 A recession causes sales to drop, creating great difficulty in servicing the loan payments.
 When loans mature, interest rates have increased substantially from when loan was last refinanced.
 Economic distress causes bankers to abruptly cease lending to small businessmen.
When evaluating a business, the Return on Equity (ROE) method can obscure the fundamentals of the business,
and should not be used. Be wary that seller is discussing rates of return from a Return on Equity (ROE)
perspective, while buyer is thinking in terms of Return on Asset (ROA). How a business is financed between
debt and equity should remain between the buyer, his financial advisors, banker and accountant. The
availability of any buyer financing resources should not be factored when evaluating the soundness of the
underlying business fundamentals. It is important to focus solely on market value by using the Return on Asset
(ROA) method. If an investment cannot stand on its own fundamentals, regardless of buyer financing, it cannot
stand at all.
Page 3 of 6
STEP 3 – CONSOLIDATE YOUR PAPERWORK
The following documents are needed to proceed with this form. When finished do not send the supporting
documents but only this form to [email protected]. Your last Retirement Update Letter will be
updated and then rerun to assess the impact on your retirement projections.
Last year’s (or latest if retired) W-2 Forms-Client & Spouse
Last year’s Tax Return
Last year’s (or latest if retired) record or estimate of hours worked at regular job – Client & Spouse
Recent business appraisal
Credit history report from Experian, Equifax and Trans Union. A free copy from each of the agencies can
be obtained from Annual Credit Report. Any errors should be cleared up immediately.
FICO score (Please note there is a cost for the FICO score but not for the credit report). This website has a
calculator which shows what people with different FICO scores can be expected to pay in different interest
rates.
Sellers financial statements if purchase or business plan if startup which should include:
1. Purchase price or cost to startup business
2. Seller’s complete financial statements or if a startup, detailed list of assets, liabilities, income and
expenses
Estimated number of non-compensated hours needed at startup and then annually – Client & Spouse
Annual unrealized capital appreciation growth rate if available
Page 4 of 6
STEP 4 – DEFINING THE HURDLE RATE PERCENTAGE
Assume a company is valued at $1,000,000 and is generating $60,000 in net profits a year. The Return on Asset
(ROA) is therefore 6%. Is the return adequate or not? Here is how people tend to answer this question:
1. Business is operating at above breakeven so return is adequate.
2. The return is greater than what can be earned at a CD at the bank, making it a good investment.
3. Making or losing money doesn’t matter because business has been in the family for years and is
therefore a sentimental investment.
4. As an employee of the business drawing a salary the net profit or loss does not matter.
5. The most common answer of all is admitting to never thinking about this question.
The problem with the answers above is that investing in a business costs time and money, which are precious
resources. Planning for retirement has enough pitfalls, without knowing whether an investment is helping or
hurting. One needs to keep all investment cylinders firing to get to the retirement objective.
How does one know if an investment is generating an adequate rate of return? The key is to have a relevant
comparison. For example, one would not compare a real estate’s rate of return to a CD rate or some other
arbitrary measure given the level of risk taken in such a venture.
Instead, the annual rate of return (ROR) percentage of the oldest global small-cap company mutual fund since
inception will be the baseline. To this baseline figure various adjustment factors will be added. The sum will
provide the minimum long-term total rate of return (ROR) percentage or Hurdle Rate. If the business’ projected
return equals or is greater than the hurdle rate then proceed, but if less the project should be avoided. If the
investment is currently owned and the rate inadequate, the business is in need of a turnaround and if that is not
feasible, liquidated to avoid dragging down one’s retirement.
Page 5 of 6
STEP 5 – CALCULATING THE HURDLE RATE FOR A BUSINESS
Description
Benchmark – The foundation is a widely diversified World Stock mutual fund. Templeton Growth
Fund A (TEPLX) long-term rate of return since 1954 is:
The factors below will bridge the risk differential between holding the widely diversified mutual
fund above and an individual property.
Geographic risk – Applicable if client does not hold small businesses across the globe. If
concentrated enter 0.50%; enter 0.00% if property holdings are world wide.
Sector risk – Applicable if client has holdings primarily in one sector (e.g. banking, retail, etc.)
instead of having diversified properies. If concentrated use 0.50%; enter 0.00% if property holdings
are across many sectors.
Leverage risk – Applicable if client has leverage as there is risk of being unable to make loan
payments and/or refinance the loan again after loan balloons in five to seven years. If financial
resources limited use 2.00%, sliding down to 0.00% if self financed.
Liability risk – Needed to reflect the possibility of legal litigation. Start with 0.75% sliding down to
.25% if significant coverage. The percentage will never go to zero as there are often frivolous
lawsuits with which to contend.
Business risk – Recognition of the possibility that the venture may fail. Depending on the riskiness of
the business start with 2.00%, sliding down to 0.50%.
Additional factors –
Additional factors –
Hurdle Rate Percentage
(Client Salary
($
1
STEP 6 – CALCULATE YOUR HOURLY RATE
+ Spouse Salary1) / (Client Hours2 + Spouse Hours2) =
+ $
) / (
+
) = $
%
12.0
===
Hourly Rate
1
Annual compensation comes from last year’s W-2 form. If retired use last year of employment.
Annual hours worked comes from payroll records. If not available, use a best estimate.
2
STEP 7 – DETERMINE COST BASIS
If business is currently in operation, skip input and place recent appraisal directly in COST BASIS field.
Purchase Price + Startup Dollar Costs1 + (Startup Hours2 X Hr Rate3) =
Cost Basis
$
+ $
+ (
X $
) = $
1
Include any other one-time startup costs from the business plan including fees, taxes, commissions and improvements. Do not include
loan payments here.
2
Include from the business plan personal hours required to get this business project started, that will not be compensated by salary.
3
Place the hourly rate calculated in step #6 here.
Page 6 of 6
Net
Income2
$
STEP 8 – CALCULATE ANNUAL ECONOMIC BENEFIT1
If the business is a startup, fill the table below with information from the business plan.
Interest
Unrealized LT Cap
(Ongoing
Hourly
Annual Economic
+
+
X
=
Payments3
Appreciation4
Hours5
Rate6)
Benefit
+ $
+ $
- (
X $
) = $
1
A business creates positive economic gains through two sources, cash flow and unrealized capital appreciation.
Annual Net Income comes from the most recent tax return, Supplemental Income and Loss (Schedule E), line 21 which shows the net
gain or loss.
3
Add back the interest only (do not include principal) on any loan payments to be made annually. Refer to the most recent tax return,
Supplemental Income and Loss (Schedule E), line 12 Mortgage interest paid to banks, etc.
4
Unrealized Long-Term Capital Appreciation is the annual increase in the value of the business. This gain will be recognized and not
converted to cash flow until the business is sold, perhaps decades from now. Refer back to the earliest income statement. Calculate
out income growth rate from the earliest income statement to the current income statement.
5
Include the personal time required annually for this business, which will not be compensated by salary. If owned for a while,
estimate what has been spent in uncompensated hours on average over the years since operation was bought or started.
6
Place the hourly rate calculated in step #6 here.
2
STEP 9 – CALCULATE LONG-TERM TOTAL RATE OF RETURN (ROR)1
Annual Economic
Projected Long-Term Total Rate of Return
Cost Basis3
/
=
2
Benefit
(ROR)
$
/ $
=
%
1
This is the annual Rate of Return (ROR) using the Return on Assets (ROA) calculation.
Calculated in step #8.
3
Calculated in step #7.
2
STEP 10 – COMPARING PROJECTED BUSINESS RETURN WITH HURDLE RATE
Projected Long-Term Rate of Return (ROR) for Business1
+
Hurdle Rate that Business Must Surpass2
Difference Between Projected Business ROR and Hurdle Rate
=
1
Calculated in step #9.
Calculated in step #5.
2
STEP 11 – EVALUATING THE FINDINGS
As the projected long-term rate of return (ROR) for the business is greater (positive) than the
hurdle rate, this test suggests that the business venture is attractive.
Or
As the projected long-term rate of return (ROR) for the business is less (negative) than the hurdle
rate, this test suggests that the business venture is unattractive.
%
%
%