New practice acquisition: Cash flow or use alternative lender?

[drdds]

I would appreciate members' advice or comments on this situation.

We have finally found a practice opportunity in the area we have been looking in for over 6 years. This is a great location for us and will definitely be profitable based on our research and our offerings. If we do not move on it, a competitor will definitely do so and we will be locked out.

Now the situation is that we had opened our first practice in a different location just over a year ago using a practice loan. So when we talk to traditional lenders (including the one we have the first loan with), they are reluctant to finance this 2nd practice due to the short time between the two practice starts even though we are very profitable at this first location. We have enough cash reserves in our corporation from the first practice as well as from retained earnings over the years to cash flow this 2nd practice acquisition as well as to run it without issues until it becomes fully profitable by itself. But we also have been researching financing options and came across the alternative lenders like OnDeck who it appears can finance this without as many restrictions as the traditional lenders. But of course their APRs are much higher (probably in the 10% range compared to 5.9% to 7.9% for traditional) even though they say they can do 6.9% for prime borrowers which we probably are.

So which path do you think we should take?

1) Cash flow using our reserves?

2) Use alternative loan and pay it off within a couple of years?

And what are the possible pitfalls or disadvantages of each path? Any problems with our whole plan in the first place? Appreciate suggestions.

[ENT Doc]

I'd want to know about your cash reserves more.  What is the purpose of your reserves?  I understand having cash in a cash account for working capital, but why the reserves?  Are there rules that govern retained earnings and these cash reserves?

[drdds]

The cash reserves are just the S-corp retained earnings from the last few years that are sitting in the S-corp account and not been distributed to the sole shareholder. We left them there for future use if needed (probably just for this kind of situation).

[ajm184]

You have a couple of challenges (and alot of opportunity).  Some additional information may be helpful.

a.  The covenants related to the current 1st practice loan?  In particular, your ability/flexibility to pull retained earnings from this business to support the potential acquisition.

b.  Is the current practice loan able to be prepaid/repaid in full?  If yes, you may be able to convince your existing lender to extend a new practice loan for the second acquisition under consideration.

c.  Have you created/sketched out a business plan for the proposed acquisition?  What timeframe do you expect to be profitable at the second location (hopefully a year or less)?

d.  Is there a possibility of a seller's note?

e.  Would the terms between the traditional lender and the 'alternative' lend be similar from a structuring/covenant standpoint, outside of rate (guaranty, collateral)?   IMO, I would try to stay with a traditional local lender as if things don't go 'just so', they will have greater willingness to work with you versus an 'alternative' lender.

[ENT Doc]

drdds wrote:

The cash reserves are just the S-corp retained earnings from the last few years that are sitting in the S-corp account and not been distributed to the sole shareholder. We left them there for future use if needed (probably just for this kind of situation).

Click to expand...

Well, I suppose this depends on what the sole shareholder wants to do then.  But you state that "we" left them there.  Who has decision making authority here?  If I were in control of this money I'd look at the returns on this investment.  If superior to the hurdle rate for the project and better than what I could achieve on my own on an after-tax basis then I'd invest the cash.  If you don't want to grow and it's not a good return then take the distribution.  Holding onto it has a large opportunity cost.  Not sure why you'd need a lender if you have the cash already and can get good returns.  The whole point of getting a loan for a home is so you can have available cash flow for better returns elsewhere in your accumulation phase.

[drdds]

Thanks very much for these points to ponder.

By we, I mean my spouse and I with me being the sole S-corp shareholder and my spouse managing everything corp-related in the background (because I know absolutely nothing about these matters).

a) No such covenant exists in the current loan language as far as we can tell. The only collateral described is the current practice location and all its contents present or future.

b) Prepayment penalty exists. Also actually talked to this bank and have been definitively rejected for a second loan. Its probably also the reason that other banks are reluctant as well.

c) Profitable in a year or less. We have done the same at our first location.

d) No seller, new startup

e) We have to check with OnDeck to see what their terms will be. Just wanted to get opinions before starting conversation with them.

Thanks again for your suggestions.

[ajm184]

a. Based on your responses, guessing this is a fixed rate original 5 year term loan.  In either case you bank is treating this like a transaction versus a relationship and you should do the same.

b.  The collateral sounds like a blanket lien on business assets.  If the loan documents allow, I would move your operating business accounts and any personal assets out of the bank somewhere else locally.  The purpose/point is in reference to a. above, your current lender views this as a transaction, not a relationship, take your business relationship somewhere else in so far as you are able.  It will send a very clear message to them, though likely won't change their tune towards getting a second business loan.

c.  I would look into a loan with an 'alternative' lender.  A couple of caveats, think hard about a personal guaranty and do not allow a prepayment penalty in the loan documents if your goal is to aggressively repay this loan.  May require a line of credit versus a term loan structure, though guessing most of these 'alternative' lenders are not match funding anyway so should be a moot point in your favor.

[ENT Doc]

drdds wrote:

Thanks very much for these points to ponder.

By we, I mean my spouse and I with me being the sole S-corp shareholder and my spouse managing everything corp-related in the background (because I know absolutely nothing about these matters).

a) No such covenant exists in the current loan language as far as we can tell. The only collateral described is the current practice location and all its contents present or future.

b) Prepayment penalty exists. Also actually talked to this bank and have been definitively rejected for a second loan. Its probably also the reason that other banks are reluctant as well.

c) Profitable in a year or less. We have done the same at our first location.

d) No seller, new startup

e) We have to check with OnDeck to see what their terms will be. Just wanted to get opinions before starting conversation with them.

Thanks again for your suggestions.

Click to expand...

Some questions for you.  The first is regarding this statement:  "We have enough cash reserves in our corporation from the first practice as well as from retained earnings over the years to cash flow this 2nd practice acquisition as well as to run it without issues until it becomes fully profitable by itself."  Cash reserves are an asset and retained earnings are equity.  Do you actually have enough cash on the asset side of the balance sheet to make this purchase while maintaining enough for working capital?

ajm184 brings up great points regarding debt financing, but I'm curious why a debt purchase is even being considered to be honest, provided the above checks out ok.  The only reason I see to do a debt purchase is if you have an even better or absolutely necessary opportunity elsewhere for that cash.  Do you?  Your rate of return vs hurdle rate assessment shouldn't differ substantially between the two (debt vs cash purchase) and the rate of return may even be better for the cash purchase.  Thus, if you're committed to the expansion plan I'm not sure where you benefit from increasing your leverage and incurring increased cash outflow in the form of interest payments.  What am I missing?

[Zaphod]

ENT Doc wrote:

drdds wrote:

Thanks very much for these points to ponder.

By we, I mean my spouse and I with me being the sole S-corp shareholder and my spouse managing everything corp-related in the background (because I know absolutely nothing about these matters).

a) No such covenant exists in the current loan language as far as we can tell. The only collateral described is the current practice location and all its contents present or future.

b) Prepayment penalty exists. Also actually talked to this bank and have been definitively rejected for a second loan. Its probably also the reason that other banks are reluctant as well.

c) Profitable in a year or less. We have done the same at our first location.

d) No seller, new startup

e) We have to check with OnDeck to see what their terms will be. Just wanted to get opinions before starting conversation with them.

Thanks again for your suggestions.

Click to expand…

he rate of return may even be better for the cash purchase.

Click to expand...

Rate of return is never better (assuming its positive, etc...) with cash vs. regular/reasonable loan. Paying cash basically gives you the lowest rate of return or the cap rate often advertised. Obviously that doesnt make it a bad choice, and leverage increases the risk going the other way of course while sharing some responsibility with the bank/insurance can also be nice.

[ENT Doc]

Zaphod wrote:

ENT Doc wrote:

drdds wrote:

Thanks very much for these points to ponder.

By we, I mean my spouse and I with me being the sole S-corp shareholder and my spouse managing everything corp-related in the background (because I know absolutely nothing about these matters).

a) No such covenant exists in the current loan language as far as we can tell. The only collateral described is the current practice location and all its contents present or future.

b) Prepayment penalty exists. Also actually talked to this bank and have been definitively rejected for a second loan. Its probably also the reason that other banks are reluctant as well.

c) Profitable in a year or less. We have done the same at our first location.

d) No seller, new startup

e) We have to check with OnDeck to see what their terms will be. Just wanted to get opinions before starting conversation with them.

Thanks again for your suggestions.

Click to expand…

he rate of return may even be better for the cash purchase.

Click to expand…

Rate of return is never better (assuming its positive, etc…) with cash vs. regular/reasonable loan. Paying cash basically gives you the lowest rate of return or the cap rate often advertised. Obviously that doesnt make it a bad choice, and leverage increases the risk going the other way of course while sharing some responsibility with the bank/insurance can also be nice.

Click to expand...

This assumes the cash is deployed elsewhere with a return superior to the loan amount, no?  Currently the cash is just sitting there with guaranteed loan APRs of 7% (7.2% APY).

[adventure]

drdds wrote:

d) No seller, new startup

Click to expand...

Okay... but who buys the land? builds the building? and/or pays the rent? and buys the stethoscopes? and pays the staff?

[jfoxcpacfp]

Cash should have a designated purpose. If your choice is use cash that is idling in your bank(s) versus a loan at 10%, use the cash. I don't know exactly why this is even a question. Given what you have described, you s/b able to again accumulate cash from the profits in business #1. Just have a plan.

Using the cash in your s-corp is a different question and definitely needs to be discussed with your CPA.

• Will you borrow from the corp? If so, have appropriate documents drawn up using AFR (Applicable Federal Rates) published by the IRS and follow the terms of the loan agreement.


• Will you distribute the cash then use for building the practice? If so, make sure you have enough "basis" in the s-corp to do so.


• Will the s-corp own the 2nd practice? An s-corp cannot own another s-corp.

[Zaphod]

ENT Doc wrote:

Zaphod wrote:

ENT Doc wrote:

drdds wrote:

Thanks very much for these points to ponder.

By we, I mean my spouse and I with me being the sole S-corp shareholder and my spouse managing everything corp-related in the background (because I know absolutely nothing about these matters).

a) No such covenant exists in the current loan language as far as we can tell. The only collateral described is the current practice location and all its contents present or future.

b) Prepayment penalty exists. Also actually talked to this bank and have been definitively rejected for a second loan. Its probably also the reason that other banks are reluctant as well.

c) Profitable in a year or less. We have done the same at our first location.

d) No seller, new startup

e) We have to check with OnDeck to see what their terms will be. Just wanted to get opinions before starting conversation with them.

Thanks again for your suggestions.

Click to expand…

he rate of return may even be better for the cash purchase.

Click to expand…

Rate of return is never better (assuming its positive, etc…) with cash vs. regular/reasonable loan. Paying cash basically gives you the lowest rate of return or the cap rate often advertised. Obviously that doesnt make it a bad choice, and leverage increases the risk going the other way of course while sharing some responsibility with the bank/insurance can also be nice.

Click to expand…

This assumes the cash is deployed elsewhere with a return superior to the loan amount, no?  Currently the cash is just sitting there with guaranteed loan APRs of 7% (7.2% APY).

Click to expand...

No, just that if the fixed amount coming in is say known/equal, if you pay less for it up front, the "cash on cash" return you paid for it is higher because you paid less today. Its something the real estate blogs are always talking about and there are definitely always leverage and always cash groups there. Any appreciation, income, etc...is more to you since you're leveraged (and vice versa).

I think its usually a whole other discussion than say the risk side of things which is different but important.

[drdds]

Hi folks,

OP here. Excellent discussion and questions raised. Let me answer some questions to clarify things:

1. All retained earnings are in cash in various places (checking, CDs, recently opened brokerage account). Until last year, the cash was just sitting earning under 1% in checking/CDs. To mitigate that, we opened the brokerage account last year and moved a bunch of cash into it. Since then bull market returned nearly 10% on it but of course, this is risky and subject to the market.

2. If we go cash route, we will take distributions as much as needed from the S-corp, not borrow cash. Yes, we have basis in the S-corp since it has no loans and all capital/revenues into it have been only from me with my earnings over the years.

3. We think we will open a 2nd S-corp for the 2nd practice to make it simpler to manage both books.

4. We will be renting a space to operate the practice so rent will be cash flowed from practice operations. No initial investment is needed for this. We need initial funds only to build and equip the practice and estimate around 250K for this. We have around 400K in the S-corp.

5. We think we will still check with the lender and see what they offer and if their terms are onerous or their APRs are very high, then we will go the cash route.

 

Thanks for all the answers and the lively discussion.

 

[ENT Doc]

Zaphod wrote:

ENT Doc wrote:

Zaphod wrote:

ENT Doc wrote:

drdds wrote:

Thanks very much for these points to ponder.

By we, I mean my spouse and I with me being the sole S-corp shareholder and my spouse managing everything corp-related in the background (because I know absolutely nothing about these matters).

a) No such covenant exists in the current loan language as far as we can tell. The only collateral described is the current practice location and all its contents present or future.

b) Prepayment penalty exists. Also actually talked to this bank and have been definitively rejected for a second loan. Its probably also the reason that other banks are reluctant as well.

c) Profitable in a year or less. We have done the same at our first location.

d) No seller, new startup

e) We have to check with OnDeck to see what their terms will be. Just wanted to get opinions before starting conversation with them.

Thanks again for your suggestions.

Click to expand…

he rate of return may even be better for the cash purchase.

Click to expand…

Rate of return is never better (assuming its positive, etc…) with cash vs. regular/reasonable loan. Paying cash basically gives you the lowest rate of return or the cap rate often advertised. Obviously that doesnt make it a bad choice, and leverage increases the risk going the other way of course while sharing some responsibility with the bank/insurance can also be nice.

Click to expand…

This assumes the cash is deployed elsewhere with a return superior to the loan amount, no?  Currently the cash is just sitting there with guaranteed loan APRs of 7% (7.2% APY).

Click to expand…

No, just that if the fixed amount coming in is say known/equal, if you pay less for it up front, the “cash on cash” return you paid for it is higher because you paid less today. Its something the real estate blogs are always talking about and there are definitely always leverage and always cash groups there. Any appreciation, income, etc…is more to you since you’re leveraged (and vice versa).

I think its usually a whole other discussion than say the risk side of things which is different but important.

Click to expand...

Ok, so finally had some free time to look at this.  Check out the attached Excel spreadsheet.  While it could be more complex the broad strokes tell the story well enough.  I even gave the benefit of interest rate deduction as it applies to after-tax cash flow.  All rates matter here - rate of return on cash invested elsewhere (stocks/bonds), loan interest rate, and after-tax rate of return on the asset in question.  Obviously, timing of cash flows matters too.  It's not unreasonable to have after-tax returns and hurdle rates near 10% for an opportunity such as the OP mentions.  These after-tax returns are put to work more in an alternative investment (stocks/bonds) absent debt involvement.  If the asset return rate is higher (which is perhaps one of the most important variables not discussed so far) then it makes even MORE sense to purchase with cash.  Play around with the numbers (green squares are intended to be modifiable under both tabs).  Let me know what you think.  But I don't think it's true, given reasonable parameters, that debt will always yield a better return.