One of my young students contacted me today with a few key concerns about how to close a deal. He talked to a banker and the banker scared the crap out of him. Seems the banker said he could wind up paying 10% of the purchase price out due due diligence costs – and never recover it. So I decided to write about it. Front end expenses will kill your motivation to do a deal. Simple as that. Why? Because people who buy businesses often, no generally, do not have enough money to throw away on unrecoverable deal expenses and then go on to the next one. Front end deal expenses are expenses you must pay before there is a certainty that the deal will close. The actual equity investment is reliably safe because it does not get paid before closing. Not so with the front end costs which can be paid into six figures before finding out that the seller changed his mind or the bank dropped its commitment.
Front end costs are a gamble and can run up to big money if you are not careful. Or once you learn how much the deal will cost, you will head for the hills. You do not want to do either. So let's examine these costs and look for a few ways to deal with them.
1. Buyer due diligence – accountant, lawyer – $ 25,000
2. Bank due diligence, lawyer, collateral audit, appraiser $ 25,000
3. Closing Fees – Legal, Real Estate, Appraisal $ 30,000
4. Bank fees – underwriting, commitment, transaction $ 100,000
Most of these costs are paid prior to closing so they are at risk.
Total: $ 180,000.
Now do not freak out, the deal does not have to be this way unless you are sleep at the switch.
This is why you must take great pains to minimize all the expenses along the way.
Here are some ways in which to do that.
1. Due Diligence on the buy side is optional – it is for the buyer's benefit only. If you paid all cash you could decide not have any due diligence and forget about it. I have a due diligence list that we ask the seller for and do a lot of review ourselves. For a $ 1.0 – $ 3.0 Million deal I would expect to pay the accountant and the lawyer maybe $ 5000 – $ 7000 in total for a minimal review. About half of this should be rolled into the closing.
2. Bank side due diligence should be mostly an audit fee with some legal work. On a $ 1.0 Million plus deal this could be maybe $ 5- $ 10,000 but should be paid towards the end of the transaction and on an hourly rate.
3. Closing Fees – Hiring the buy side lawyer can get expensive since you are drafting and negotiating the purchase contract. Some deal lawyers will work for out of pocket expenses and take a flat percentage at closing (say 1%) with half of that due if the deal does not close. This can save a lot of up front costs.
4. Bank Fees – If the bank charges you more than $ 5,000 up front to underwrite the deal negotiate hard or get a new bank. They will need some money up front but it is negotiable. Payment fees or transaction fees which could be a percentage of the price will run into large dollars but are only paid out of closing and from load performed. So there should not be any problem there.
So revised picture for front end costs could look like this if the deal fail fairly early on in the process:
Buyer Due Diligence – $ 1,000
Bank Due Diligence – $ 1,000
Closing Fees – $ 2,000 for contract work
Bank Fees – $ 5,000 non refundablewriting fee.
With this scenario you could lose $ 9,000 prior to closing if the deal fell apart. It could be more or less but this reflects a very prudent money management. I will say that I have done deals with a lot less at risk. Once the contract and financing are buttoned down you have spent considered money but then the deal is nearly complete and has a much better chance of closing.