The acquisition of asset-heavy businesses such as manufacturing, poses unique challenges, particularly when it comes to business valuation and deal structuring. This article shares insights from M&A participants and industry experts, offering a comprehensive guide for buyers navigating these complex transactions.
Understanding the Valuation Challenge
When assessing the value of an asset-heavy manufacturing business, it’s crucial to separate the valuation of the business from that of its assets, particularly real estate and machinery. Many brokers often lump these components together, resulting in high EBITDA multiples that may not reflect the true value of the operational business.
Real Estate vs. Business Operations
Jackie Hirsch, a seasoned broker, suggests starting by deducting a hypothetical rent from the EBITDA to account for the real estate. This adjusted EBITDA gives a clearer picture of the business’s operational performance without the influence of real estate value. As she notes, “Deduct a rent that you would pay for that property. From that point, create a cash flow or excess earnings valuation on the business portion. Then add that to the real estate and see if the numbers work with the loan and also deducting a salary for you as well as a manager.”
Adam Rose, a corporate real estate advisor, agrees with separating real estate, emphasizing the importance of obtaining an independent valuation of the property. He advises, “I’d reach out to a commercial real estate broker who can help you value the real estate itself. They’ll probably show you the numbers for what a sale-leaseback would look like and if it’d make sense.”
The Importance of CAPEX in Valuation
For asset-heavy businesses, CAPEX (Capital Expenditure) is a critical factor that cannot be overlooked. Using EBITDA as the sole measure of profitability can be misleading, especially when significant ongoing investments in machinery and equipment are required.
Scott Rosenshein, an experienced business owner, highlights the pitfalls of ignoring depreciation in EBITDA calculations. He explains, “You may need to include some depreciation in the earnings. For instance, if a tree trimming company has 10 trucks, each valued at $1M and the expected useful life of that truck is 10 years, then you’d expect to have to pay $1M a year to buy a new truck just to sustain current levels of revenue.”
Similarly, Matt Holmes advises that buyers should consider EBITDA after ongoing CAPEX. He states, “EBITDA is the wrong measure for a business that has regular and heavy CAPEX. You should look at EBITDA AFTER ongoing CAPEX and then deduct any upfront capex required by the machinery day 1 from the purchase price.”
Key Factors in Structuring the Deal
When structuring a deal for an asset-heavy manufacturing business, it’s essential to consider both the financing and the long-term sustainability of the business.
Tatenda Mpofu emphasizes the importance of cash return on the purchase price, particularly after maintenance and growth CAPEX. He advises, “What’s your cash return on the purchase price (after maintenance and normalized growth capex)? Is that a sufficient return?”
Vipin Singh suggests exploring SBA 504 loans for the real estate component, which can offer longer amortization periods and potentially lower loan payments. He notes, “With land and building, you could try SBA 504 loans with a longer amortization period and hopefully lower loan payment, allowing you to increase your salary.”
Financing Options for Acquiring Asset-Heavy Manufacturing Businesses
When it comes to acquiring an asset-heavy manufacturing business, financing the business purchase is one of the most critical aspects to consider. The complexity of these deals often requires a mix of different financing strategies to balance the purchase price, ongoing operational costs, and future capital expenditures. This section delves deeper into the various financing options available, offering a more detailed analysis to help buyers navigate this challenging aspect of the acquisition process.
SBA Loans: A Popular but Complex Option
The U.S. Small Business Administration (SBA) offers several loan programs that are particularly useful for acquiring asset-heavy businesses, such as the SBA 7(a) and SBA 504 loans. These loans are attractive due to their favorable terms, but they come with specific requirements and limitations that buyers must carefully consider.
SBA 7(a) Loans
The SBA 7(a) loan is one of the most commonly used financing options for small business acquisitions. This loan can be used for a variety of purposes, including purchasing real estate, machinery, and equipment, or covering working capital needs. One of the significant advantages of the SBA 7(a) loan is its flexibility. It allows buyers to finance both the business operations and real estate under a single loan, provided the real estate makes up at least 51% of the total purchase price.
Brad Hettich, a commercial lending expert, explains the benefit of this approach: “If the real estate is 51% or more of the purchase price, you can do one SBA 7(a) loan and finance all of the debt over 25 years. This structure can significantly reduce the monthly payment burden compared to shorter-term loans.”
However, when the real estate component is less than 50%, the loan may require a blended amortization period, which could range between 10 and 17.5 years. This shorter amortization period may lead to higher monthly payments, potentially straining the cash flow of the business in the early years post-acquisition.
SBA 504 Loans
For buyers focusing on the real estate component, the SBA 504 loan is another attractive option. The SBA 504 loan program specifically targets the purchase of fixed assets, such as real estate and equipment, offering long-term, fixed-rate financing with lower down payment requirements.
Vipin Singh highlights the advantages of this loan type: “With land and building, you could try SBA 504 loans with a longer amortization period and hopefully lower loan payment, allowing you to increase your salary.” This longer amortization period can be particularly beneficial in asset-heavy businesses where maintaining sufficient cash flow for operational expenses and CAPEX is critical.
However, SBA 504 loans require the borrower to contribute at least 10% of the total project cost, with the remaining 90% split between a certified development company (CDC) and a participating lender. This means buyers must be prepared to inject more equity into the deal, which can be a challenge for some, especially in high-value transactions.
Check out our guide on SBA loans for business acquisitions.
Sale-Leaseback: Unlocking Capital from Real Estate
One financing strategy that is gaining popularity, particularly for asset-heavy businesses with significant real estate holdings, is the sale-leaseback arrangement. In a sale-leaseback, the buyer purchases the business but immediately sells the real estate to a third-party investor and leases it back under a long-term lease agreement. This approach allows the buyer to reduce the initial capital outlay, freeing up cash that can be used for other purposes, such as working capital or further investments in the business.
Jonathan Hoffman discusses the advantages of this strategy: “If you want to minimize your SBA loan, you could look into selling the real estate and entering into a long-term lease, and putting the deal contingent on finding a buyer for it.”
Sale-leaseback arrangements can be particularly beneficial in situations where the real estate component significantly inflates the purchase price, making the deal difficult to finance through traditional means. By separating the real estate from the business, buyers can focus their financing efforts on the operational side, which may offer more favorable terms and rates.
However, it’s essential to approach sale-leasebacks with caution. The terms of the lease, including the length, rent escalations, and purchase options, must be carefully negotiated to ensure that the business remains financially viable. As Andrew VanderPloeg advises, “I would expand upon that and ensure that any lease has a purchase option, or a framework similar to a lease to own arrangement. That way you ultimately end up with real estate. And ensure you get a long-term lease with a locked-in escalation in rate – so everything is crystal clear.”
Leveraging Equipment Financing
For asset-heavy manufacturing businesses, the equipment component often represents a substantial portion of the purchase price. Equipment financing can be an effective way to cover the cost of machinery and other fixed assets without depleting working capital or taking on excessive debt.
In many cases, equipment financing can be structured as a loan or a lease, depending on the specific needs of the business and the condition of the equipment. Filip Valica mentions that some machinery suppliers offer financing options that can reduce the upfront capital required: “Some machinery suppliers also have financing to reduce CAPEX outlay. I have heard lenders will lend up to 70-85% of PPE fair value, and some considerably less given the realities of trying to recover against those assets on default.”
Equipment loans typically have shorter terms compared to real estate loans, often ranging from three to seven years, depending on the expected useful life of the equipment. Interest rates for equipment loans can vary based on the lender, the borrower’s creditworthiness, and the condition of the equipment. Newer equipment may qualify for lower rates and longer terms, while older equipment might come with higher rates and shorter terms due to the increased risk of obsolescence or failure.
Equipment leasing, on the other hand, allows the business to use the machinery for a specified period without owning it outright. This can be advantageous for businesses that require frequent upgrades to stay competitive or for those that operate in rapidly changing industries where technology evolves quickly. At the end of the lease term, the business may have the option to purchase the equipment, renew the lease, or return the equipment.
Blended Financing: Combining Multiple Sources
Given the complexity of asset-heavy business acquisitions, many buyers opt for a blended financing approach, combining multiple sources of capital to optimize the deal structure. This might involve using an SBA loan for the business operations, a separate loan or sale-leaseback for the real estate, and equipment financing or leasing for the machinery.
Eric Gall emphasizes the importance of a detailed analysis when considering CAPEX needs in such a financing structure: “Building on the CAPEX discussions above, ‘manufacturing’ covers such a broad spectrum of activities. The quality of equipment can be incredibly important. Simply peanut-buttering a historical CAPEX across future cash flow projections can get you in a lot of trouble.”
A blended approach allows buyers to tailor their financing to the specific needs of the business, taking advantage of the best terms available for each component. For example, a buyer might use an SBA 7(a) loan for the working capital and operational aspects of the business, a commercial mortgage for the real estate, and a lease for the equipment. This not only spreads the risk across different lenders but also maximizes the financial flexibility of the business post-acquisition.
Creative Financing: Exploring Alternative Options
In addition to traditional loans and leases, buyers might consider more creative financing options to structure their acquisition. These can include:
- Earnouts: Where a portion of the purchase price is contingent on the business achieving certain financial milestones post-acquisition. This reduces the upfront payment and aligns the seller’s interests with the future performance of the business.
- Seller Financing: In which the seller agrees to finance a portion of the purchase price. This can be especially useful in situations where traditional lenders are unwilling to finance the entire deal due to the perceived risk.
- Mezzanine Financing: A hybrid of debt and equity financing, where the lender provides a loan that can be converted into equity if the loan is not repaid. This type of financing is often used to fill the gap between senior debt and equity, offering more flexibility but at a higher cost.
- Private Equity Investment: Bringing in a private equity partner can provide additional capital and expertise, particularly for larger transactions or those involving significant growth opportunities. However, this often involves giving up some control over the business.
Common Pitfalls and Considerations
Several experts outlined common mistakes and critical considerations when evaluating and structuring deals in this sector:
- Depreciation and CAPEX: Ignoring these can result in an overestimation of the business’s value.
- Supply Chain Risks: Asset-heavy businesses often have significant exposure to supply chain issues, which must be factored into the valuation.
- Environmental Liabilities: Particularly for manufacturing businesses, potential environmental cleanup costs can be substantial and should be investigated thoroughly.
- Employee Skillsets: The skill level required to operate specialized machinery can add to the operational risks if not properly assessed.
- Seasonality and Cyclical Trends: Many manufacturing businesses are subject to seasonal demand fluctuations or cyclical trends that can impact long-term profitability.
Ted Leverette, known as The Original Business Buyer Advocate, summarized these concerns succinctly, listing common errors made by buyers such as underestimating depreciation, neglecting customer concentration, and ignoring maintenance costs. He cautions, “Consider these errors and omissions by potential buyers when they analyze and value asset-heavy manufacturing businesses.”
Conclusion: A Balanced Approach to Valuation and Structuring
Acquiring an asset-heavy manufacturing business requires a nuanced approach to both valuation and deal structuring. By separating the valuation of the business from its assets, carefully considering CAPEX requirements, and exploring creative financing options, buyers can avoid common pitfalls and make informed decisions.
The consensus among industry experts is clear: a detailed and methodical approach is essential. As Sydney Guerrero aptly puts it, “Breakdown and value each component separately. This way you get a more accurate representation of what you are buying plus the math is easier to figure out.”
For those considering such an acquisition, the advice is unanimous: take your time, get expert help, and ensure you fully understand the financial dynamics at play. With careful planning and due diligence, acquiring an asset-heavy manufacturing business can be a lucrative venture.
FAQ
Frequently Asked Questions
When valuing an asset-heavy manufacturing business, it’s crucial to separate the value of the business operations from the value of its assets, particularly real estate and machinery. Other key factors include assessing CAPEX needs, depreciation, and the quality of the equipment. Additionally, considering the business’s cash flow after CAPEX and maintenance expenses is essential to understanding its true profitability.
Separating the valuation of real estate from business operations provides a clearer picture of the business’s operational performance. Real estate often has different value dynamics compared to the business itself, and combining the two can lead to an inflated valuation. By isolating these components, you can more accurately assess the business’s profitability and ensure the deal structure is financially viable.
There are several financing options available, including SBA 7(a) and 504 loans, sale-leaseback arrangements, equipment financing, and blended financing approaches. Buyers may also consider creative business financing options such as earnouts, seller financing, mezzanine financing, and private equity investment. Each option has its benefits and should be chosen based on the specific needs of the business and the buyer’s long-term goals.
SBA 7(a) loans can finance both the business operations and real estate if the real estate makes up at least 51% of the purchase price, allowing for longer amortization periods. SBA 504 loans, on the other hand, are designed specifically for purchasing fixed assets like real estate and equipment, offering favorable terms but requiring a higher equity injection from the borrower.
A sale-leaseback involves selling the real estate to a third-party investor and leasing it back under a long-term lease agreement. This strategy reduces the initial capital outlay, freeing up cash that can be used for other purposes, such as working capital or further investments in the business. It’s particularly beneficial when the real estate significantly inflates the purchase price, making the overall deal more affordable.
Using EBITDA as a valuation metric can be misleading in asset-heavy businesses because it often ignores significant ongoing CAPEX needs and depreciation. These businesses typically require substantial investments in machinery and equipment, and failing to account for these expenses can result in an overestimation of the business’s profitability.
Equipment financing allows buyers to cover the cost of machinery and other fixed assets without depleting working capital. It can be structured as a loan or a lease, depending on the specific needs of the business and the condition of the equipment. This type of financing is particularly useful when the equipment represents a substantial portion of the purchase price.
Common pitfalls include underestimating depreciation and CAPEX needs, neglecting to assess environmental liabilities, overlooking supply chain risks, and failing to account for the specialized skillsets required to operate the machinery. Additionally, ignoring the impact of seasonality and cyclical trends on the business’s cash flow can lead to financial difficulties post-acquisition.
A blended financing approach allows buyers to combine multiple sources of capital, optimizing the deal structure to suit the specific needs of the business. For example, an SBA loan might be used for working capital and operations, a commercial mortgage for the real estate, and a lease for the equipment. This diversification of financing sources can help spread risk and enhance financial flexibility.
To ensure a successful acquisition, buyers should conduct thorough due diligence, including a detailed analysis of the business’s financials, assets, and liabilities. Engaging with experts in real estate, equipment, and SBA financing is also crucial. Buyers should carefully consider the financing structure, including exploring creative options, and ensure that all aspects of the deal align with their long-term business goals.
