How much cash to keep after you buy a business

Most of the math in buying a business is about closing day: the down payment, the closing costs, the loan. With an SBA loan, we plan on 10% down and about 4% in closing costs, so your cash covers about 14% of the price. Divide your cash by 0.14 and you get the most a lender's math would let you pay.

That number is a ceiling, not a target. A buyer who spends every dollar at closing owns a company with no cushion, and the first year of ownership is when you need one most. Plan for three more things: the money the business needs to operate, a reserve for surprises, and your own living costs.

1. Working capital: the money the business runs on

Working capital is the money a business needs to keep operating between doing the work and getting paid for it. Payroll goes out every week or two. Suppliers want to be paid. Customers may take 30 days or more to pay their invoices. A company that sells products may also need to keep inventory on the shelves.

Here's the trap. In many purchases, the seller keeps the cash in the company's bank account, and sometimes the money customers already owe as well. If so, you start on day one with an empty account and a full payroll. Your first collections arrive weeks later.

To estimate what you'll need:

• Find the monthly costs, not counting the owner's pay: payroll, rent, materials, insurance, everything.
• Find how long customers take to pay. The accounts receivable aging report, one of the financial documents to ask for, shows this.
• Multiply. If customers pay in about a month, plan to cover about a month of costs before money comes in. If they take two months, plan for two.
• Add inventory and seasonality. A business that's busiest in summer may need more cash in spring.

Then read the purchase agreement carefully, because what's included matters. Do the receivables (money customers owe the company) come with the business? How much inventory are you getting? Is there a working capital adjustment, which changes the price at closing if the company has more or less than an agreed normal level? Put the basics in your letter of intent, so there are no surprises later.

You don't have to fund all of this from your own pocket. An SBA loan for a business purchase can include money for working capital, and the lender has to analyze whether the business will have enough for at least the next 12 months. You can also set up a working capital line of credit alongside the purchase loan. Ask your lender which makes sense for your deal.

2. A reserve for surprises

Something will go wrong in the first year. You don't know what, which is the point of a reserve. Common candidates:

• Equipment breaks. The truck or machine that seemed fine when you checked the company before closing isn't.
• A customer leaves. Some customers use a change of owner as a reason to shop around.
• A key employee quits, and you pay more to replace them, or pay overtime while you look.
• Costs the seller didn't have. A seller who had a family member do the books for free, or put off repairs, leaves those costs to you.
• Insurance and storms. In Florida especially, insurance renewals and hurricane season belong on the list.
• Transition costs. New software, updated signs and paperwork, legal and accounting help.

Our post on risks that change the price is a good checklist for what could hit this particular company. Size the reserve to match. A company with old equipment and one big customer needs more cushion than one with a young fleet and hundreds of customers.

3. Your own living costs

The salary you plan to take has to cover your household. An SBA lender checks this: the owner pay in its analysis must cover your living expenses. But plans slip. The first payroll comes before the first collections, and a slow first quarter is the moment you'll be tempted to skip your own pay.

Keep a personal emergency fund that's separate from the business. If your household depends entirely on the company and the company has a bad month, you want a cushion that doesn't come from the business account. And try not to drain your retirement savings to close the deal. Where the down payment comes from covers the trade-offs of each source.

Putting numbers on it

Say you have $250,000 of cash and need a $100,000 salary. Your ceiling is about $1.8 million ($250,000 ÷ 0.14). Rather than go that high, you look at a company with about $1.2 million in yearly sales, about $100,000 a month, and owner earnings (profit plus what the owner pays themselves, before loan payments and taxes) of about $300,000. At 3 times earnings, the price is $900,000.

• At closing: 14% of $900,000 is about $126,000, leaving you about $124,000.
• The loan: $810,000 at about 10.25% over 10 years costs about $130,000 a year, around $10,800 a month. After your salary, the company has $200,000 left, about 1.5 times the payment, comfortably above the 1.25 SBA rules require.

Now set the remaining $124,000 against the three buckets:

• Working capital: the company's costs, not counting the owner's pay, run about $75,000 a month, and customers pay in about 30 days. If the receivables stay with the seller, plan on about $75,000 to get through the first month.
• A reserve: say two months of loan payments, about $22,000.
• Living costs: say three months of household expenses at $8,000 a month, $24,000.

That's about $121,000, nearly everything you have left. At the ceiling of $1.8 million, you'd have had nothing. This is why a company well below your maximum is often the better buy.

Ways to need less cash

• Ask for the receivables, or a normal level of working capital, to come with the business, and reflect it in the price.
• Include working capital in the SBA loan, or set up a line of credit at closing.
• Ask the seller to finance part of the price. A note on full standby can reduce the cash you bring; see seller financing explained.
• Buy a smaller company. It's the most reliable way to keep a cushion.

One more thing to discuss with your lender. As where the down payment comes from explains, an SBA lender has to consider whether a buyer with far more cash than the deal needs could fund more of it. The rules also let the business keep reasonable funds for working capital and its equipment needs over the next two years, so explain your plan for the cash you're keeping.

What to do this week

• For a company you're considering, estimate monthly costs and how long its customers take to pay.
• Write down your household's monthly costs and decide how many months you want set aside.
• Rerun your numbers at a price well below your ceiling, and compare what you'd have left.
• Ask your lender how they'd handle working capital on a deal your size.

For what to do with that cash once the business is yours, see your first 90 days as the new owner.