Journal

Jan 08

Preparing to Sell Your Business – Step Six: Dealing with Real Estate

Journal entry by steve, Jan, 08 2015

This series of articles examines the steps that a business owner should walk through in preparing for a business sale transaction. To request a copy of the full series to date, please contact michelle@piedmontbusiness.com.

 

Step Six:  Dealing with Real Estate

For many business owners, owning the real estate from which the business operates and paying for it out of business operations over a period of years is a key financial benefit of owning a business. In fact, for many small business owners the real estate is a key component of overall business value and an important retirement funding vehicle. Other businesses lease the facilities from which they operate, and those facilities are often critical to business operations. Alternatively, leased facilities may be an albatross that burdens the value of the business as a whole. Whether facilities are owned or leased, there are a number of factors to consider in preparing for an eventual sale of the business.

Ownership of real estate can be of great value and benefit at the time of sale, so long as the business owner has operated the business long enough to have sufficient equity in the real estate. Aside from its value as an asset, owned real estate will permit the owner greatest flexibility in structuring a sale transaction. Some business owners prefer to sell the real estate with the business, cashing out the entirety of their investment and divorcing themselves entirely from the business operations. Others will prefer to retain the real estate as an investment, leasing it to the new business owner on terms structured along with the business sale transaction. On the other side of the transaction, some purchasers will want to own the real estate so that monthly “lease” payments go toward building equity, while others will not want to incur the additional exposure, drain on cash and risk that come with buying a business and real estate together. The real estate may provide additional or extended financing opportunities for a buyer, increasing the value of the business as a result of the extending financing terms or additional funding available to the buyer. Often, the business owner who is open to either selling or leasing the real estate will be able to present the opportunity to the largest pool of prospective buyers, obtaining the highest value for the business. Ideally, the business is marketed with the real estate being available for lease or purchase.

An important consideration with owned real estate is that the real property should be analyzed and considered apart from the business. In that manner, the real estate can be considered independent of whether it will be sold or leased, and will provide a more accurate perspective of the value of the business operations apart from the real estate – in the same way the business will be analyzed by the buyer’s lender’s business appraiser and underwriting department. Typically real estate is owned in a separate, affiliated business entity or personally by the business owner, and rent is not paid, or rent is paid only when there is sufficient cash flow, or (most frequently) rent is paid in whatever manner is most advantageous for tax purposes. Financial statements should be adjusted, if necessary, to reflect payment of a hypothetical fair market rate of rent and other expenses by the business. If the business is paying non-typical real estate-related expenses – such as mortgage principal and interest or capital improvements – these should be added back to cash flow. The business owner should view the business from the perspective of a buyer who will be leasing the business at a fair market rental rate and terms, whether or not that is the intended structure. Recasting financial statements to reflect market terms and lease structure will allow the business to be viewed from the same perspective as the buyer and his lender, and will provide defensible values for both the business and the real estate.

Once the financial statements are adjusted to reflect arms-length lease terms, the real estate can be valued apart from the business based on market terms. If the business owner chooses to obtain an appraisal or market analysis to assist with determining the value of the real estate, this is the same approach that the appraiser or analyst will take. Thus the business and the real estate can be valued and viewed as two distinct assets, with distinct pricing if they are sold together. If the real estate will be leased, the “market” rental rate factored into the financial analysis of the business will be easy to justify, since the adjusted financials present a picture of the business “as if” it were leasing the property on those terms. In our experience, the result is relatively little negotiation of lease terms by the buyer once the business pricing is agreed. A caution, though, is that the hypothetical lease rate and terms used in recasting financial statements should reflect reasonable terms on which the owner will actually agree to lease the properties to a buyer if the property is leased; otherwise, the recast financials will be difficult to justify and the buyer will have to further adjust the figures to factor in agreed lease terms.

As addressed briefly in Step Four (Managing Contracts and Liabilities), the business owner leasing real estate should take several steps well in advance of marketing the business to prepare for the eventual sale. For one, assignability of leases for key business facilities must be considered carefully. If the lease is not freely assignable without landlord consent (most are not), the business owner should ideally obtain landlord consent to a future transfer in advance of marketing the business. The conversation with a landlord about lease assignment will be far easier when other, seemingly more important issues are under consideration. For example, when negotiating terms for a significant lease extension and the landlord is demanding an additional few dollars per foot, it may be relatively inconsequential to the landlord to agree to allow future assignment of the lease to a buyer of substantially all the assets of the business – particularly if the selling business owner will not be released from liability if the buyer fails to make lease payments, which is most often true. (“I would love to sign this 7-year extension and have full confidence in my business in doing so, but what if I want to sell it in a few years, will you allow me to transfer the remaining lease term to the buyer?”) However, the conversation can be far more challenging with a difficult landlord when the business is already under contract, and some landlords have been known to exact “their share” of the sale transaction as a condition to giving consent to transfer the lease – even though the selling business owner will remain secondarily liable if the buyer fails to pay.

As with assignability, other terms of key leases should be addressed if possible in advance of marketing the business. If the storefront, warehouse or manufacturing facilities are important to business operations, the lease should have a sufficient remaining lease term (with extension options) at fair market terms and rates in order to protect the buyer’s investment in the business. The buyer’s lender will generally require that the lease have a remaining lease term that equals or exceeds the new loan amortization, particularly if the loan will be SBA-guaranteed. If it will cost $100,000 to relocate the business and the lease must be renegotiated in a few years, the buyer is likely to take the anticipated relocation cost into consideration and discount the value of the business. Of course the selling business owner will not agree with the adjustment, but business owners often accept more risk and uncertainty in their businesses than the average buyer will accept, particularly if the buyer perceives he is paying an aggressive valuation for the business. Typically the business owner will have done their best to negotiate most favorable lease terms with an unrelated landlord and there is not a lot to be gained there, but the business owner contemplating future sale should consider that the lease terms will have a direct impact on the business valuation.

Real estate can also be a drain on the business. The current business owner may occupy property that is less than ideal for current business operations, simply because the real estate is owned. A buyer with great interest in the business operations may be reluctant to lease the seller’s real property for any significant period of time, fully intending to move the operations at first opportunity. If the business owner insists on selling the poorly-suited real property with the business or leasing it long-term, the buyer will discount the value of the business or pass on the opportunity entirely. Similarly, leased real property that is superfluous to the business, personal to the owner or poorly suited to operations should be leased for short periods of time, if at all. A common example is office or storage space used in a business that a buyer may want to consolidate into other operations, move to another location, or convert to a home-based business. For some businesses the real estate is a critical component of value, while for others relocatability and flexibility increase business value.

The most important consideration with owned or leased real estate, as with many aspects of preparing a business to sell, is to view the business and real estate from a typical buyer’s perspective. Who are the likely buyers of the business, and how will they view the facilities? Obtaining the advice and counsel of advisors, or anyone who can provide an unbiased consideration, can be quite helpful for the owner who is perhaps too close to the business to see it from that perspective. Real estate, whether owned or leased, can have a negative impact on business valuation. However, positioned and structured properly, the facilities and properties of a business can provide competitive advantage and add significant value to the business.

Coming Next – Step Seven:  Improving Value Drivers

 

Stephen C. Minnich, J.D.
Certified Business Intermediary
Piedmont Business, LLC
(336) 202-7905
www.piedmontbusiness.com

 

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