Question:

If you buy a business and you’re getting a loan, how much capital should you have available until the business starts generating income? For example, if I have $100,000 should I be looking for a business that’s $50,000 keeping some back or should I look for a business that’s over and try to find financing for the overage.

Answer:

Thank you for your excellent question. Believe it or not, many buyers overlook this and wind up in trouble soon after they acquire a business. What you are trying to determine is known as the

“working capital” requirements of the business. This is the amount of money you will need available to fund the business after you take over until it becomes self-sufficient

, meaning that there is enough inflow of cash to pay the bills.

Unfortunately, there isn’t a standard answer, but it is something that you can easily calculate. Keep in mind that every business scenario is different. For example, if you acquire a business where clients pay immediately (i.e. a retail store), then you will have an inflow of cash the first day that you take over. On the other hand, if it’s a business where you grant payment terms to clients and the average time to collect is 30 days, then at a bare minimum, you will need at least one month of working capital (although I don’t think that 30 day’s worth is enough, but I’ll explain in a moment).

The other thing to consider is inventory. If you will have to purchase products to sell prior to seeing payments form clients, here too your cash flow will be affected.

The best way to approach this for any business is to do a forecast for the first six months after closing. Generally, you should take the average monthly revenue for the past 2 – 3 years. Then, factor in any seasonality to the business. For example, if you are buying a water sports equipment rental business on the beach in Florida in May, you can certainly expect sales to be far higher than they will be in December.

Once you determine the average sales, then you must calculate all of the fixed costs that you will incur from day one. These are all of the expenses that the business will have that are not related to the sales. For example, if you have sales people on commission, their costs are only incurred when revenue is generated. On the other hand, rent is a fixed expense. You have to pay this regardless of what the business revenues may be. Other fixed costs include: utilities, payroll, insurance, taxes, etc.

Always add a cushion of at least 10% – 15% to cover miscellaneous costs that always arise for new business owners. Let’s assume that the fixed costs are $5,000 per month. Add another $750 to be comfortable.

Once again be certain that you include any anticipated inventory purchases into the equation if applicable to the business you are buying.

Then, you will need to factor in the revenue and how it is collected. If you sell products and don’t collect for 30 days, you know that you will be in the hole for at least the first month’s fixed expenses and catch up in month two. However, I have found that most businesses show a slight decline after a new owner takes over for the first 90 days or so. Each business is different but figure on about 15% – 20% decline.

In summary, here’s what to consider:

• Complete a forecasted profit and loss statement.
• Be ultra-conservative in both revenues and expenses.
• Discount prior year’s revenues.
• Increase fixed costs to give yourself a cushion.
• Don’t forget about inventory.
• Don’t panic if the business declines a bit after you take over.
• Do not allow yourself to get into a cash crunch.

• If possible, try to have three months of working capital available.