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Before you commence your search for a business, it is a helpful to have an idea of what you can afford. This prevents you from wasting your time pursuing businesses, which are beyond your means. The majority of businesses do not sell for cash. In fact, it’s common to finance about two-thirds of the selling price. That means you are looking at making a down payment of around one-third of the selling price. This is the logic behind the rule-of-thumb known as the ‘Rule of Two-Thirds’, which states; “The cash flow from the business must be able to service a debt of two-thirds of the selling price”.
In other words, after paying all the expenses involved in running the business, there must be enough money left over to cover the payments due on the debt incurred to buy the business. If there is a shortfall, it cannot be considered a high-profit business. If you still decide to buy the business you will have to either increase the amount of down payment or increase the number of years over which the loan is amortized in order to reduce the amount of monthly or annual debt service.
The following questions will help in determining your financial investment comfort level so that you know how much cash you have available for a business. Based on the Rule of Two Thirds, if you multiply the amount of cash you have to invest in a business by 3, you will have a rough dollar estimate of the size of business you can afford. Some purchasers will ask for a copy your net worth statement to assess if you are a qualified buyer.
The financial factors, which are most important in assessing your potential investment level, can be divided into two areas:
The first step is to calculate your net worth and unencumbered capital. Different people may have the same total net worth, but assets can be distributed differently among liquid assets and equity, thereby making it easier for one person to finance a business than another.
Essentially, your personal financial statement appears very much in the same format as that of a company. You have assets on the one hand and liabilities on the other. Your assets are all the things that you own. They are your cash in the bank, your life insurance surrender value, and the value of your home and your RRSPs – even small items such as golf clubs.
On the other hand, your liabilities fall into two categories: Your liabilities are monies you owe to other people including banks, mortgage companies, credit cards, taxes and so on. Your liabilities are monies, which you consider you owe to yourself. So, in other words, if you take all the things that you own (your assets) and subtract all the money you owe to other people (your liabilities), you are left with your net worth (e.g., if your sole possession is your home which is valued at $400,000, and you have a mortgage of $200,000, your net worth would be $200,000. That is the money you would owe to yourself when you sell your home and pay off your liabilities.)
From the point of view of calculating your net worth for the purposes of obtaining bank, trust company or credit union financing, it must be understood that a bank is not interested in smaller items that you own, such as golf clubs, nor does the bank necessarily want you to cash in your RRSPs. Banks look at large assets, which are those that can be sold realistically in the event of a need to pay off the loan. So, the most important of these is your home. If you were to own shares in a publicly traded company, which is recognized by the bank as a stable venture, then these shares may also form some additional security or collateral for a loan.
Your investment in a business will come from two sources: first loans against assets; and second, from your unencumbered capital or liquid assets from which you can obtain cash in order to invest in a business.
Some of your assets may be mortgaged or have other monies owing against them such as your home or vehicle. The bank will normally be very interested in using your home as security in a stable housing market; however, it has to take into consideration that if there is a mortgage against the home, it can effectively reduce the realization value upon resale. The following example may assist in clarifying this situation.
If your home is worth $400,000 and has a mortgage of $300,000 against it, the bank will be unable to use it as collateral for advancing further funds. The simple reason is that a bank will require a 25% safety margin on your home to provide for the eventuality of a decrease in real estate values. If your home is worth $400,000 and has a mortgage of $200,000, then a bank may advance you 75% of the $400,000, less the $200,000 which is already owed against the home (i.e. $100,000).
“Unencumbered capital’ is a term used to describe your liquid assets, or assets which can be readily liquidated or sold for investment purposes. These are assets such as cash in the bank, perhaps loans that you have made to others, which are easily collectible, stocks and bonds, which you can readily sell on the stock market, and RRSPs for that matter. These are quite different from assets such as real estate which would not normally be sold, but which can be used for collateral.
Although a bank may be prepared to lend you sufficient monies against your home, given that there is sufficient equity, and you are able to liquify some of your other assets to raise cash for your investment, you should also pay close attention to the extent of your liabilities. By borrowing additional funds and by liquifying your assets and investing them in a business, you may be placing yourself at undue risk, given that you may already have excessive liabilities for other reasons. To put it simply, if you already owe too much money and have limited cash reserves to use with further borrowings against your home to start a business, you can quickly get yourself into financial difficulties, even if the business is otherwise a good opportunity.