Automotive Buy Sell Report
July 8, 2015
By Joseph S. Aboyoun
A key component of every buy-sell is its capital structure. The purchase of a motor vehicle dealership presents some unique challenges in this regard.
I. Franchise Requirements
The goal is to ensure that your capital structure meets and preferably exceeds the requirements of the subject franchise. These requirements are readily available from either the selling dealer or the manufacturer. Of course, the latter is the advisable source since these requirements can change from time to time. Your advisers, especially if well-versed in automotive deals, can also guide you on this aspect.
The requirements fall into two separate categories. The first is the working capital requirement. The second is the net worth requirement. The latter also entails compliance with the franchisor’s debt-to-equity requirement.
II. Working Capital
Each manufacturer has working capital guidelines for a particular dealership. These are usually based upon the so-called planning volume (PV) of the store. Specifically, it is calculated on the amount of new vehicles projected to be sold by the particular dealership, multiplied by a specified dollar amount- e.g. $1,000.00 per new car sold. As such, if the store is projected to sell two thousand (2,000) vehicles per year, the working capital requirement would be $2,000,000.00.
In assessing an acquisition, these requirements must be ascertained as soon as possible so that the total cost of the acquisition can be determined from the outset. This cost falls into three (3) categories:
- The price of the deal, excluding vehicles and parts;’ I
- Working capital; and
- Transactional costs- e.g. legal and accounting fees and due diligence expenses (e.g. — environmental inspection)
As an example, if the negotiated purchase price for the store is $4,900,000.00, consisting of blue sky and fixed assets (excluding vehicles and parts), and the working capital requirement is $2,000,000.00, and the transactional costs are estimated to be $100,000.00, the total cost of the deal would be $7,000,000.00. This is the amount of the total investment to be considered in approaching the acquisition and in developing a funding plan. Of course, this increases significantly if the real estate also becomes a part of the acquisition, although the real estate is customarily and substantially funded by a mortgage (typically 70-80%).
III. Debt-To-Equity
Once the total investment is determined, it is crucial to address the manner in which the required funds with be generated. These typically come from three (3) possible sources:
- Your own personal capital;
- Borrowed funds- i.e. debt; and
- Third-party equity- e.g. partners or co-investors
Wherever or however the funds are derived, the key element from a franchise approvability perspective is to remain in line with the factory’s so-called debt-to-equity ratio.
This requirement is readily available when processing your franchise approval application. Customarily, it is a one-to-one standard. In other words, for every dollar of borrowed funds (debt), you are required to contribute a dollar of your own funds (equity). With this approach, the manufacturers are able to maintain a sound capital structure for its franchisees.
Of course, if all of the required investment was generated through debt arrangements, the dealership would be severely undercapitalized and as such, in great risk of failure or, at minimum, underperformance. Conversely, all manufactures recognize the role of debt in the overall funding structure of a deal. Applying a one-to-one ratio to the dealership acquisition example in part 2 above, the funding could be derived from a $3,500,000.00 acquisition loan and $3,500,000.00 from equity loans.
It is noteworthy that some manufacturers may exclude the working capital loan from the one-to-one requirement. As such, the debt may exceed equity. In the example above, the total debt would be $4,550,000.00, consisting of a $2,550,000.00 acquisition loan ($5,100,000.00 divided by 2) and a $2,000,000.00 working capital loan. The equity funds would only by $2,550,000.00. However, this is the exception to the rule and one is cautioned against this approach unless it is clearly supported by the manufacturerL2 1.
IV. Equity Fund: Corroboration & The "Unencumbered" Requirement
There are two (2) critical factors in determining the source of the equity funds to be contributed toward the acquisition. The first is the corroboration of these funds to the franchisor. Every franchise application includes a so-called source of funds statement. This component requires a detailed explanation of the source of each dollar of the equity funding. This might take the form of a buyer’s personal investment portfolio (e.g. C.D.’s or cash management funds). It might also be derived from the buyer’s other businesses- e.g. a distribution or dividend from one of the buyer’s other dealerships. No matter the source, it must be both identified and verified.
The other requirement is to prove that the contributed finds are not "encumbered". Most factories frown upon the contribution of capital which is personally-borrowed funds. For example, if instead of deriving equity funds from a broker account or on another store, the buyer were to borrow the money from a second mortgage on his home or other property, he would be considered a risky candidate for the manufacture’s perspective for obvious reasons.
This is not to say that all of the equity funds must be unencumbered. Some franchises do relax this aspect somewhat. It is more a manner of degree and prudence. When it is all said and done, the capital structure for the acquisition must make sense from both the manufacturer’s perspective and yours.
V. Third-Party Equity: Risks
Deriving the required funding from third-party equity presents unique challenges. First, in deciding to involve a co-investor, the buyer should consider associated risks and complexities. These include issues involving control (particularly operational control), management compensation and distribution rights. Of course, the most significant risk is an ultimate partnership dispute.
Second, if the equity partner is an equity or hedge fund, the risk is further heightened by the possibility of the manufacturer’s rejection. Some manufacturers have voiced an objection to such equity participants in dealership acquisitions. Clearly, this objection is suspect under most franchises statutes.
If carefully structured, a deal involving an equity fund partner should pass muster under these laws. However, the buyer should be cognizant of this risk. He should be aware of the possibility that the franchisor may exercise its right of first refusal in such deals. As such, the deal should be structured in such fashion as to minimize that possibility to the largest extent possible.