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Liquidated Damages, Arbitration/Mediation Clauses

Liquidated Damages & Arbitration/Mediation Clauses in Purchase Contracts

In many purchase contracts today there are two special clauses that must be initialed individually to be included in the contract. If both the buyer and seller do not initial the clauses they are not part of the contract.

The first is Liquidated Damage. Barron’s Law Dictionary defines Liquidated Damages, as “An amount stipulated in the contract which the parties agree is a reasonable estimation of the damages owing to one in the event of a breach by the other”.

I have found that many people do not fully understand what the liabilities are of agreeing to this clause. Let’s take it in three steps; what is the clause for? When does it go into affect? What are the ramifications of signing this clause?

The clause’s purpose is to bind the buyer to the contact, and put the buyer in the position of loosing money if he backs out of the deal without good reason.

The clause goes in affect after the buyer have been provided all of the financial information requested in the purchase contact and the buyer has had time to review that information. The contract has a clause that says the buyer usually has 10 or 15 days to review the documents before being asked to sign a document that says you have done your due diligence and are satisfied with what you have reviewed. When that is done the escrow can continue with the steps necessary to close the purchase.

If the purchase contract includes a contingency for creating a new lease or assuming an existing lease the buyer needs to get with the landlord and arrange to be approved, by him, for the new or assumed lease. When that is done and the buyer is approved, in writing, the purchaser(s) will again be asked to sign the document releasing the lease contingency that says the buyer is satisfied with the lease arrangement with the landlord.

This written document releasing the contingencies for the lease and financial information are called "Removal of Contingency Form." Only after this form is signed or a written letter stating that the buyer is removing all contingencies does the Liquidated Damage Clause, in the contract, go into action.

It is important to note that the contingency removals cannot happen automatically. They must be removed in writing. In years passed the contract would say the buyer had 10 days to remove contingencies, and if the buyer didn’t notify escrow, in writing, that there was a problem, the contingency was removed automatically and the buyer was assumed to have approved the documents and lease terms. No more, the courts decided that the buyer should not loose his right to object, automatically and now buyers have to sign a written document stating that the contingencies are removed.

If a seller or his agent is not aware of this change, in the law, the buyer may never be asked to remove the contingency and it will remain open during the whole escrow. This means that the buyer can back out of the deal without penalty.

The correct procedure is for the seller’s agent, when the review period is reached, to send a notice to the buyer requesting the written removal of the contingencies within a 24 hour period or the seller can cancel the escrow. The buyer then usually signs the “Removal of Contingency Document or writes the letter to escrow. If the buyer doesn’t do this, the seller cancels escrow and gives the buyer back his deposit.

Again, signing this Liquidated Damage clause and then releasing the contingencies, activates the clause. If the buyer backs out of this escrow for any reason, except something that is the seller’s fault, the buyer will loose 100% of his deposit.

Why would anyone sign this clause? The alternative to not signing this clause may be worse than signing it and loosing your deposit. If the buyer backs out of the deal for no good reason the seller can and probably would do the following: First he would refuse to let escrow return the buyers deposit. Without an agreement between both the buyer and seller the escrow cannot do anything. This would result in the money sitting in escrow until the parties sue each or settle out of court. No one knows who will win in a lawsuit and how an out of court settlement will go?

Second, if they go into court the seller(s) will argue to the Judge that the buyer backing out of the deal damaged him. The seller would present arguments about of monetary damages that were suffered and ask the Judge for all the deposit plus more, to cover the damage. This gives the Judge total power to decide what the buyer will be charged for backing out of the purchase. Sometimes the Judge feels that the seller should get nothing. One example would be the case where the seller found a new buyer and resold the property/business to another buyer for an amount equal or greater. The reverse could also be true.

If the second buyer paid a lower price, the Judge may then decide to charge the first buyer for the difference in sale prices-the loss between the two prices. I have found from experience that some Judges do not make intelligent decisions with regard to these matters. I will not say they are crazy but some can appear that way on business issues.

Conclusion about Liquidated Damages: Going to court is like flipping a coin, or maybe it is more like Russian roulette. One thing is for sure the bad guy always wins, referring to the attorneys.

The second is Arbitration/Mediation.  Arbitration and Mediation are both methods of avoiding lawsuits. They do however still involve attorneys and a paid mediator. Lets start with the definitions of the word Arbitration: “Arbitration is a process where disputing parties present their disagreement to an impartial third party for the purpose of making a determination of the outcome. This third party, called a neutral, (third party), makes a determination based on evidence presented during the arbitration process. Evidence is given the appropriate "weight it deserves" as most rules of evidence are relaxed in the arbitration process.” – Cohen & Associates, Inc.

Mediation: “Mediation is a consensual dispute resolution process where a neutral third party assists the disputing parties in coming to a mutually agreeable solution. The mediator has no power to impose a decision as he would if he were an arbitrator or judge.” – Cohen & Associates, Inc.

Mediation is preferable to a lawsuit or arbitration. The mediator tries to help the parties to reach a settlement and no one is subject to a decision being forced upon them. Of course, no one likes to be forced to do anything against his or her will. But if the parties do not come to an agreement, the parties leave and fight it out in the court system.

If you agree to arbitration, the arbitrator is like a judge. His decision is final, with no right of appeal. The advantage to arbitration is that it is all over in less than 3 months instead of 1 to 2 years of stress and paying your attorney to go to court hearings.

The advantage of speed is a very important issue. The longer things drag-on the more money it costs, and the more upsets there are which affects your work, social life, home life and health.

Here are your choices. As a buyer you get to make your choices and live with it. The seller may demand that you agree to arbitration and of course you can refuse, possibly killing the deal.

So, there you have it, the ins and outs of liquidated damages and the low down on arbitration/mediation.

Tags: buying a business selling a business
Categories: Deal And Escrow Issues
Posted at: 4:26pm  |  0 Comments  |  Share This Blog Post  |  Save This Blog Post

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Adult Day Care Centers - Cash Flow Matters

Is the claim that there is big profit in Day Care Centers, too good to be true?

Are Adult Day Care Centers making the big money they claim?

Last year I was asked to do a business evaluation and financial review of an Adult Day Care Center in Ventura County and render an opinion as to the profitability and viability for a client wanting to buy this business for the full asking price or for any other price. I was told before I began, that it was clearing $50,000 per month profit, and the asking price was $3 million.

Up to that point I had never reviewed a Day Care Center, but I had prospective buyers that had themselves been studying the industry, and telling me all about what they learned in their investigations. They still wanted my opinion as to the viability and profitability of buying a Day Care Center. They wanted a second opinion as to what the risk factors are in buying a Day Care Center. Business buyers rarely used to look at the risk factor of the businesses they want to buy. I think now that has changed. The risk factor being what is the likelihood of what is happening today will continue into the future at the same level.

One of the red flags in Summer 2007 for Adult Day Care Centers was that a very large number of them were for sale. Why were they for sale, was the subject of my research project? What I determined, was known to every Day Care Center owner, but was never mentioned.

The big risk factor for this industry is cash flow. Every year the State of California has to approve its budget. If the budget is not approved, all employees and vendors, which included ADCC, (Adult Day Care Centers) do not get any payments until the budget is signed. Some years it is two weeks, but others have gone as long as two and a half months. Imagine having a $50,000 monthly payroll and $10,000 monthly rent and no income for two and a half months. Of course, once the budget is approved they receive all of their money instantly.

There was another problem in 2007. Seniors who were qualified before 2007 were no longer eligible for the State of California to pick up the cost. The enrollment numbers in the centers took a drop at that time because this, but now that change has settled out and is no longer an issue.

Of course, when you are dealing with Governments and Legislators, things change all the time. Your business can be outlawed overnight. This is one of the big risk factors. The other is that the State of California could go bankrupt in this current economy. We could say that is not likely but can we say it is impossible? Remember when Orange County filed bankruptcy?

To get back to the ADCC in Ventura; my due diligence and financial review showed that the $50,000 profit the seller talked about was his projection for the month. We were in the middle of that month at the time. Up until the current month the business had been making $30,000 per month. Since my client's resulting offer was at a substantially lower price, it was refused.

Six months later another client hired me to review the same business. This time I received more up-to-date financials, allowing me to understand what the business had actually made, rather than the projection I had received earlier. The business never reached the $50,000 level, but did reach $45,000 three months later. The profit, as calculated by the seller, was very creative but not real. I determined the correct lower profit. The asking price was reduced to $2 Million and my second client offered $1.2 Million, which was also refused.

I am waiting for the next price change and my next client. We will see what happens then.

Tags: business valuations due diligence buying a business
Categories: Business Valuation
Posted at: 6:05am  |  0 Comments  |  Share This Blog Post  |  Save This Blog Post

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Bottom Line: Computing Adjusted Net Income

It's known by more than a dozen short phrases and acronyms and it is one of--if not THE--key factor buyers look at when evaluating business offerings as likely purchase candidates.

How much money remains after payment of all the expenses needed to conduct business? That's the question on buyers' minds as they review a company's profit and loss statement. And it's usually the same figure to which sellers refer when they promote the value of their enterprises. And though the principals may be thinking of the same magic number, they're approaching it from opposite sides of the transaction, and often confusing one another by using different ways to describe it.

In the interests of promoting better communication among those involved in the purchase and sale of small and mid-market companies, it might be useful to clarify the idea that business people mean to convey when they talk about the amount of money still in the cash drawer or company bank account, after the revenues are collected and the bills are paid.

TWO WAYS TO MEASURE

Much of the mix-up has to do with the fact that there are two basic ways to measure earnings generated by a company. The first approach follows the straight-forward calculation used to arrive at the amount remaining after subtracting out the cost of goods sold, salaries, employer contributions, and selling expenses, then deducting all necessary overhead items such as rent, utilities, insurance, maintenance, marketing, bank and credit card costs, and fees paid for professional and other outside services, and the miscellaneous costs required to operate.

It's this first definition of profit that buyers want to know about and that sellers want to emphasize as the "true profit." That's because it's invariably higher than the one resulting from the second way of defining a company's earnings.

This second approach, usually expressed fully in a company's profit and loss statement, is different from the first calculation because it includes subtractions of allowable deductions so the owner can show a smaller bottom-line sum on which to pay taxes.

Typically, these allowable deductible items include taxes paid, interest on sums borrowed to help fund the company, cash reserves being accumulated to replace capital assets (depreciation), and recovery of investments previously made in the firm with after tax dollars (amortization).

Not only do these allowable deductions represent expenses not absolutely necessary to conduct business, they also reflect highly individualized ways of funding and managing tax liability involved in a business. The seller's "earnings" as calculated to determine tax liability, may be quite different from the figure on the P&L for the same company, once it's owned and operated by the buyer.

DISCRETIONARY EARNINGS

While marketing a company and quoting the earnings figure on the profit and loss statement--and that's the figure on which taxes will be calculated, the seller wants to convey to prospective buyers that if they run business exactly as the seller has, they will have more money to use than the figure listed at the bottom of the current P&L. The seller or seller's broker, explains that any expenses listed, but not needed for the successful performance of the business, should be "added back" to the stated profit, and that the result is the seller's discretionary earnings.

This explanation is intended to help buyers understand that anyone who takes over the business and runs it the same way--assuming revenues and costs are unchanged--will have the same discretionary earnings to allocate for expense items used to reduce tax liability, with the balance treated as income subject to taxation.

It is the effort to communicate this principle that results in the use of various terms intended to define what is meant by earnings. That's when buyers encounter phrases such as seller's discretionary earnings (also expressed as SDE), earnings before interest, taxes, depreciation and amortization (commonly referred to as EBITDA), seller's discretionary cash (SDC), and various other terms, including adjusted net and adjusted annual cash flow.

SOME ALERTS

Buyers should be aware, incidentally, that other so-called expenses might be properly added back to determine the cash actually produced by the business. Included are the owner's personal expenses, health and life insurance premiums, auto expenses not related to the business, and obvious tax "dodges" such as salaries paid to the owner's family members even though their contribution is not worth what they earn.

Buyers also need to know that some "discretionary" allowable deductions do involve a real cost. If the seller carries back part of the purchase price, the interest paid on that loan does not have to be included as income subject to taxation, but it is a real expense. Another example is depreciation. Some income dollars may be declared non-taxable because they are set aside to replace capital assets, although not actually spent in the year the deduction is taken. But at some point most every business owner has the need to replace equipment, and that will entail an actual cost to the business.

The shorthand terms and acronyms used to aid in business sales discussions can help buyers and sellers communicate if both know what they're talking about. And it's usually a good idea for parties to get their accountants involved to make sure these conversations don't contain misunderstandings.

Tags: due diligence business valuations buying a business selling a business
Categories: Business Valuation
Posted at: 9:14am  |  0 Comments  |  Share This Blog Post  |  Save This Blog Post

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Buying A Bed And Breakfast Inn

Many owners of a bed and breakfast business--or the "country inn" variation in which dinner is also provided to guests--report that they thoroughly enjoy their enterprise, even though it might involve more hours of labor than they'd expected.

Owners and brokers advise that prospective buyers for this kind of enterprise spend some time in the area where a purchase candidate has been identified, to make sure the locale--including its weather and amenities--seem agreeable. Also important is that a prospective buyer is prepared for the amount of work involved, and has some understanding about the financial part of the business.

HOW MUCH PROFIT TO EXPECT

While there is little information, readily accessible to the public, regarding net earnings generated by this type of resort property, there are some revealing statistics posted by a key trade group representing owners in the industry. According to the PAII (Professional Association of Innkeepers International), an average sized inn features eight rooms, each offered at daily rates averaging $166.00, and experiencing--in the 2006/2007 period--43% occupancy.

Using these figures and doing the math produces a total of about $200,000. That's what the owner of an eight-unit inn can expect the property to generate in annual revenues, if its numbers line up with the average enterprise in this business. Industry standards place labor costs--not including the work of the owners--at 10% to 15% of gross, while "cost of goods" items--supplies and food included--account for about 20%, and overhead (utilities, maintenance, insurance, taxes, advertising and marketing, phone and internet, professional services and related costs) adds up to about 30% to 35% of gross.

Based on these calculations, the owners (note that B&B properties almost always are owned and operated by a couple) of this hypothetical, but average business would receive about $68,000, perhaps as much as $80,000 a year in return for their financial investment and hard work. Part of this sum, incidentally, will be allocated for depreciation and amortization, service of any debt incurred to purchase the business, and taxes paid on the net income.

It's unlikely the prospective buyer will encounter an offering with numbers that exactly match this financial model. But the information and percentages presented here might be useful references when analyzing a bed and breakfast or country inn for purchase.

QUESTIONS TO ASK

And this analysis might serve to remind buyers of the key questions that should be asked, such as: Number of rooms, average daily rate, occupancy level and amount of expenses in each category.

Considering the slowdown in the economy, a purchaser also wants to know, when analyzing a business, what marketing efforts are being pursued, or can be instituted, in an effort to minimize the loss of business as consumers cut back on travel and related spending. Is the property able to accommodate wedding parties and other celebrations? Is this capability promoted aggressively? What about providing a meeting venue and lodging for members of business, social and religious groups?

The ability to expand beyond the travel market can be an important marketing advantage for B&Bs and country inns in this economy.

PRICING

With the majority of properties in this business accommodating guests in eight or fewer rooms, it is the real estate that represents the major value driver. An appraisal of the property and furnishings is the basis in determining the correct price for a modest-sized B&B. The amount added for the business varies between $25,000 and $75,000, depending on the location and profitability of the enterprise.

Pricing of larger facilities is a function of income, with a factor of between 5.0 and 6.0 multiplied by annual gross revenue to arrive at a value. The higher multiple applies to properties in excellent condition and sold with seller financing for 10% or 20% of the purchase price.

Small business buyers wanting to maximize the return on the investment of their money and time may do better with a convenience store or fast food business. But if part of that return is measured by the proximity to tall pines or clear blue lakes, a bed and breakfast inn might be the right choice.

Tags: buy a business buying a business
Categories: Buying A Business
Posted at: 6:22am  |  0 Comments  |  Share This Blog Post  |  Save This Blog Post

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Buying A Grocery Store - Top Tips

Ideal as a family business in which parents and teenaged children can be involved, the grocery store is a model for the way that people in America, sometimes lacking advanced education or financial sophistication--and perhaps not quite fluent in the English Language--still can achieve some security and independence through hard work, usually accompanied by a modest style of living. They can take over a grocery enterprise with only basic business skills, and will learn--along the way--some fundamental lessons about buying, merchandising, promotion, pricing, spoilage control, customer relations, and about how to conduct an efficiently run, cost-managed enterprise.

POSITION IN THE MARKETPLACE

A good location or a special product offering, such as ethnic foods of a specific type, or a focus on fresh produce, can insure a niche position in the market area. With enough demand from people in the neighborhood, the store will generate the level of business needed to support its owners. Another way for a food retailer to carve a slice out of the market is to remain open during hours when competitors in the neighborhood are closed.

There is a danger, as some grocery operators have learned, in becoming so successful that other operators want to share in the market demand created by that initial entrepreneur, and proceed to open competitive businesses in the area. Another risk is that the lease expires, and cannot be renewed, forcing the owner to go out of business.

Changing demographics of the area is a problem encountered by some grocery store operators. A growing area often provides the lure for a grocery chain, which almost invariably will take most of the business previously enjoyed by the smaller operators. And a declining area plagued by an increase in crime and abandoned residences, will almost certainly cause local grocery store owners to discontinue their businesses.

EVALUATION CRITERIA

So a prospective buyer of a grocery store should make it a point, first of all, to evaluate the area where any purchase candidate is located. Is it likely that the neighborhood will change? Are there other, similar businesses in close proximity? Do they pose a threat to the future livelihood of the store being examined? Are customers coming to the targeted business for its particular offerings, such as a deli counter, a wide selection of fresh pastries, a large fresh produce section, or a video rental service?

The financial criteria used to evaluate a prospective purchase in this business should include the industry's standard cost factors. If the cost of goods, for example, is below 70% of the gross revenue figure, the storeowner is either very smart about purchasing, is able to collect above-average markups, or both. Another reason for a gross profit above 30% might be that some of the revenue represents sales of, for example, sandwiches and soups made to order, with cost of goods factors in the 30% to 40% range.

Occupancy cost--rent, utilities, maintenance, and insurance--should not exceed 7% of gross sales, if the company is to be profitable. And if payroll costs are more than 20% of gross revenues, it may be a sign the owner is not putting in the long hours commonly worked by most operators in this business. That also might suggest that he, or she is not collecting earnings of 10% or more--the minimum figure that many operators hope to achieve.

Another important figure to know is the pricing rule of thumb for independent grocery businesses. While a buyer should expect to pay--and the seller expect to receive--a figure equal to twice the seller's discretionary annual earnings, that multiplier may be adjusted upward, or down, based on length of lease, whether a substantial (30% or more) portion of the price is financed by the seller, and the condition of the premises.

Since everyone needs to buy food, a neighborhood grocery store--if it is selected carefully and purchased at the right price and terms--can be a secure, rewarding opportunity in which to invest.

Tags: buy a business buying a business
Categories: Buying A Business
Posted at: 10:54am  |  0 Comments  |  Share This Blog Post  |  Save This Blog Post

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Negotiating Tips: Selling, Buying A Business

When a business buyer and business owner/seller are tired of sending offers and counters back and forth without achieving a satisfactory resolution, it might be time to meet face to face. And to be effective, parties might borrow some ideas from skilled negotiators. Ten ideas to use when negotiating are:

1. KNOW WHAT YOU WANT.  Seems simple enough, but one reason people don't settle on a deal is because they change their minds, in response to changes proposed from the other side. Be clear about your bottom line and stay with it.

2. LISTEN TO THE OTHER PARTY. When people who feel they're being "heard," they become much easier to work with than if they believe their concerns are ignored.

3. ESTABLISH RAPPORT. Chatting about the weather and the recent performance of the home team, at the beginning of the conversation, is not a waste of time if it helps the parties "warm up" to each other.

4. BEGIN WITH WHAT YOU AGREE ON. That's how diplomats "broker" a cease fire between warring factions. They find a common ground, get both sides to agree on some basic principals, although small, and then proceed, from that foundation of agreement, to address bigger issues.

5. KEEP EMOTIONS IN CHECK. Volatile personalities can magnify small differences into critical, anger provoking issues. Remain cool and think before speaking or acting.

6. SLOW DOWN. When demands and counter demands are exchanged quickly, there is no time for either party to think through what he or she is trying to accomplish. Conducting the discussion at a methodical pace helps to prevent those brash statements that disrupt a mutual accord. The mutual accord is what parties need to achieve if they're going to have an agreement.

7. BE WILLING TO GIVE AND TAKE. When someone thinks the differences cannot be resolved, he or she often is surprised that by moving a little toward accommodating the other person, and the other person doing the same, there suddenly is a point at which they meet in the middle.

8. MAKE SURE YOU ARE CLEAR ON CONCEPTS. Misunderstandings often arise because there was no understanding about what was being discussed in the first place. When I say "profit" is it calculated the same as when you say "earnings"?  Are we really in agreement about the exchange of receivables and payables? What does that mean to you? Do you understand it the same way I do?

9. PLAY "WHAT IF!"  There is room for creative ideas when negotiating. If a fresh idea can break a stalemate, it needs to be introduced. Suggesting a possible compromise as a "what if?" is a non-threatening, non-demanding way to get the other party to join you in thinking "outside the (negotiating) box" in which you both might be trapped. Example: "What if you agree to buy all the inventory, and I agree you can take six months to pay for it?"

10. USE THE BROKER. An experienced intermediary not only knows how to act as a "third party" who can dispassionately notice what the principals can't see (because they're too close), but also can draw on experience to bring additional and useful information into the discussion. One negotiating block was overcome when the broker let the seller know he could take a promissory note from the buyer, then sell it--at a discount--to get the cash he needed.

To get discussions moving forward, and maybe toward a mutually-acceptable agreement, parties are advised to meet up at the bargaining table, and bring with them some negotiating skills.

Tags: buying a business selling a business
Categories: Deal And Escrow Issues
Posted at: 9:35am  |  0 Comments  |  Share This Blog Post  |  Save This Blog Post