Selling a business is like “The Perfect Storm.” There are many controllable and uncontrollable variables coming together at just the right time and place to optimize the value received by the owner. It is the uncontrollable externalities that often cause an otherwise perfect sale to go bad.

Assume we have a company valued a year ago at $2 million based on good trends and consistent earnings before tax, depreciation and interest of $700,000 annually. Further assume that at the time of the valuation, interest rates on small business commercial borrowings were at 8%. Everything about this company has remained consistent with last year’s performance; however, borrowing rates are now at 10% or 25% higher (2% / 8% = 25%) than last year. Rising interest rates also means that this buyer’s opportunity cost relative to his or her choices for investing in this company changes. In other words, this buyer could forgo this investment and put his / her cash into something that has less risk for a double- digit return. If he / she originally wanted a 20% return for the risk involved in purchasing a business, shouldn’t that return-rate now be adjusted to compensate for a 25% increase in borrowing costs?

Now assume we have a fairly sophisticated buyer, who will finance 70% of the purchase price, or $1.4 million. Therefore, the buyer’s cash investment to purchase the business will be $600,000 ($2,000,000 price - $1,400,000 loan = $600,000 cash).

For simplicity sake, let’s see how this change in “relative” rates might affect this buyer’s overall cost of capital. This approach simply multiplies the Borrowing Rate x Percent Borrowed (70%) plus the Return on Investment Rate x Percent Cash Invested:

Buyer Equity = 30% x 20% = 6.00%
Buyer Debt = 70% x 8% = 5.60%
Cost of Capital = 11.60%

Buyer Equity = 30% x 25% = 7.50%
Buyer Debt = 70% x 10% = 7.00%
Cost of Capital = 14.50%

Note: Rates equate to both buyer’s opportunity cost to reinvest down payment plus borrowing costs as a percent of the purchase price