Financing the Business Acquisition
The epidemic of corporate downsizing in the US has made owning a business a more attractive proposition than ever before. As increasing numbers of prospective buyers embark on the process of becoming independent business owners, many of them voice a common concern: how do I finance the acquisition?Prospective buyers are aware that the credit crunch prevents the traditional lending institution from being the likely solution to their needs. Where then, can buyers turn for help with what is likely to be the largest single investment of their lives? There are a variety of financing sources, and buyers will find one that fills their particular requirements. (Small businesses - those priced under $100,000 to $150,000 - will usually depend on seller financing as the chief source.) For many businesses, here are the best routes to follow:
Banks and other lending agencies provide "unsecured" loans commensurate with the cash available for servicing the debt. ("Unsecured" is a misleading term, because banks and other lenders of this type will aim to secure their loans if the collateral exists.) Those seeking bank loans will have more success if they have a large net worth, liquid assets, or a reliable source of income. Unsecured loans are also easier to come by if the buyer is already a favored customer or one qualifying for the SBA loan program. When a bank participates in financing a business sale, it will typically finance 50 to 75 percent of the real estate value, 75 to 90 percent of new equipment value, or 50 percent of inventory. The only intangible assets attractive to banks are accounts receivable, which they will finance from 80 to 90 percent. Although the terms may sound attractive, most business buyers are unwise to look toward conventional lending institutions to finance their acquisition. By some estimates, the rate of rejection by banks for business acquisition loans can go higher than 80 percent. With any of the acquisition financing options, buyers must be open to creative solutions, and they must be willing to take some risks. Whether the route finally chosen is personal, a seller, or third-party financing, the well-informed buyer can feel confident that there is a solution to that big acquisition question. Financing, in some form, does exist out there.Buyer's Personal Equity
In most business acquisition situations, this is the place to begin. Typically, anywhere from 20 to 50 percent of cash needed to purchase a business comes from the buyer and his or her family. Buyers should decide how much capital they are able to risk, and the actual amount will vary, of course, depending on the specific business and the terms of the sale. But, on average, a buyer should be prepared to come up with something between $50,000 to $150,000 for the purchase of a small business.
The dream of buying a business by means of a highly-leveraged transaction (one requiring minimum cash) must remain a dream and not a reality for most buyers. The exceptions are those buyers who have special talents or skills sought after by investors, those whose business will directly benefit jobs that are of local public interest, or those whose businesses are expected to make unusually large profits.One of the major reasons personal equity financing is a good starting point is that buyers who invest their own capital start the ball rolling - they are positively influencing other possible investors or lenders to participate.
Venture CapitalVenture capitalists have become more eager players in the financing of large independent businesses. Previously known for going after the high-risk, high-profile brand-new business, they are becoming increasingly interested in established, existing entities.
This is not to say that outside equity investors are lining up outside the buyer's door, especially if the buyer is counting on a single investor to take on this kind of risk. Professional venture capitalists will be less daunted by risk; however, they will likely want majority control and will expect to make at least 30 percent annual rate of return on their investment.Lending Institutions
Banks and other lending agencies provide "unsecured" loans commensurate with the cash available for servicing the debt. ("Unsecured" is a misleading term, because banks and other lenders of this type will aim to secure their loans if the collateral exists.) Those seeking bank loans will have more success if they have a large net worth, liquid assets, or a reliable source of income. Unsecured loans are also easier to come by if the buyer is already a favored customer or one qualifying for the SBA loan program.
When a bank participates in financing a business sale, it will typically finance 50 to 75 percent of the real estate value, 75 to 90 percent of new equipment value, or 50 percent of inventory. The only intangible assets attractive to banks are accounts receivable, which they will finance from 80 to 90 percent.
Although the terms may sound attractive, most business buyers are unwise to look toward conventional lending institutions to finance their acquisition. By some estimates, the rate of rejection by banks for business acquisition loans can go higher than 80 percent.
With any of the acquisition financing options, buyers must be open to creative solutions, and they must be willing to take some risks. Whether the route finally chosen is personal, a seller, or third-party financing, the well-informed buyer can feel confident that there is a solution to that big acquisition question. Financing, in some form, does exist out there.
Financing the Business Sale -- Some Questions to Answer!Structuring the purchase of a business is an issue that should be faced early in the selling decision. Ultimately, the final structure of the sale will be determined by actual negotiations between buyer and seller, but the seller must still answer the following questions: What is the lowest amount of cash acceptable from the sale? Has consideration been given to paying off all unsecured creditors and a portion of the closing costs? (Both are, in most cases, the seller's responsibility.) Is there any long-term or secured debt that can be assumed by the buyer? (This may make more cash available to the seller.) What is an acceptable interest rate for the seller-financed sale? Will the business be able to service the debt and still provide a return acceptable to a buyer in relation to the down payment required? (This is a particularly important question for the seller to address.) What are the tax consequences of the sale?
Recent studies indicate that the more favorable the terms, the higher the price. In fact, one study found that offering favorable terms might increase the total selling price by 30 percent. A business broker professional can advise you on the all-important issue of seller financing.The professional business broker is a good source for assistance in structuring the sale of a business. Although they are not able to provide legal advice, business brokers are the experts of preference when the arena is the business marketplace. Brokers will use their knowledge of previous sales, current market conditions, and outside financing strategies, if applicable or available. A business generally represents a seller's largest financial asset. How the sale is structured may mean the difference between the success or failure of the transaction. The best sale structuring will result in the best deal possible for both buyer and seller. A business broker can be the key player in accomplishing this goal.
Friends and Family: A Financing Option
The first job facing many prospective business owners is rounding up the cash necessary to make the purchase. They may find that banks have made borrowing difficult (or all but impossible), and that even SBA loans have requirements too stringent to meet. One viable option is obtaining financing from the seller; another is to seek help from family and friends.
Borrowing money from family members and/or friends is one of the most frequently-used methods of small business financing. The pluses are obvious--there is trust, familiarity, and a general comfort level when dealing with those you know. The drawbacks are self-evident as well: "doing business" with family and friends comes with cautionary notes of legendary proportions. Everybody knows that family ventures can be complex and stressful, stirring up "bad blood" and lingering ill will. However, by taking the right preventive steps, buyers can take advantage of friendly financial help.
1. Set up an informal meeting to introduce your ideas.
This is the time to "feel out" friends and relatives casually, being sure they understand that this is strictly a fact-finding (and fact-presenting) meeting. Anyone who is not interested or cannot afford to be involved has plenty of opportunity to say so without feeling obligated--or emotionally "blackmailed."
2. Follow up with a professional business plan.
Those who have indicated interest should now be treated with utmost professionalism. A formal business plan, including detailed financials, and a carefully-drafted business contract should be presented at this subsequent gathering. Consult a business professional for help in establishing a schedule for repayment based on the appropriate interest rates. Nothing will inspire more confidence in lenders than the care taken with this vital paperwork.
3. Be clear about the structure of the business envisioned.
How much voice are investors to have in the business? This is a vital question. Be sure that all parties understand whether this is to be a simple investment or some sort of partnership, and put this agreement in writing.
4. Take care in identifying your borrowing "targets."
Sometimes willing and eager family members can't really afford to invest. If possible, try to spread the borrowing around so that no one person bears the crux of the loan. It may take more energy to get smaller amounts from a larger circle of people, but the safety factors for all concerned will more than compensate for the time spent.
5. Keep your investors involved.
Once the buyer becomes an owner and the new business is in operation, friends and family lenders are due more than their repayment. They will want to be informed and updated about the progress of the business. Keeping in touch is a cost-free way to return the vote of confidence your friendly investors have placed in you.
Venture capitalists have become more eager players in the financing of large independent businesses. Previously known for going after the high-risk, high-profile brand-new business, they are becoming increasingly interested in established, existing entities. This is not to say that outside equity investors are lining up outside the buyer's door, especially if the buyer is counting on a single investor to take on this kind of risk. Professional venture capitalists will be less daunted by risk; however, they will likely want majority control and will expect to make at least 30 percent annual rate of return on their investment.
Small Business Administration
Thanks to the US Small Business Administration Loan Guarantee Program, favorable financing terms are available to business buyers. Similar to the terms of typical seller financing, SBA loans have long amortization periods (ten years), and up to 70 percent financing (more than usually available with the seller-financed sale).
SBA loans are not, however, a given. The buyer seeking the loan must prove stability of the business and must also be prepared to offer collateral - machinery, equipment, or real estate. In addition, there must be evidence of a healthy cash flow in order to insure that loan payments can be made. In cases where there is adequate cash flow but insufficient collateral, the buyer may have to offer personal collateral, such as his or her house or other property. Over the years, the SBA has become more in tune with small business financing. It now has a program for loans under $150,000 that requires only a minimum of paperwork and information. Another optimistic financing sign: more banks and lending institutions are now being approved as SBA lenders. In most business acquisition situations, this is the place to begin. Typically, anywhere from 20 to 50 percent of cash needed to purchase a business comes from the buyer and his or her family. Buyers should decide how much capital they are able to risk, and the actual amount will vary, of course, depending on the specific business and the terms of the sale. But, on average, a buyer should be prepared to come up with something between $50,000 to $150,000 for the purchase of a small business.
The dream of buying a business by means of a highly-leveraged transaction (one requiring minimum cash) must remain a dream and not a reality for most buyers. The exceptions are those buyers who have special talents or skills sought after by investors, those whose business will directly benefit jobs that are of local public interest, or those whose businesses are expected to make unusually large profits.
One of the major reasons personal equity financing is a good starting point is that buyers who invest their own capital start the ball rolling - they are positively influencing other possible investors or lenders to participate.
Seller Financing
One of the simplest - and best - ways to finance the acquisition of a business is to work hand-in-hand with the seller. The seller's willingness to participate will be influenced by his or her own requirements: tax considerations as well as cash needs.
In some instances, sellers are virtually forced to finance the sale of their own business in order to keep the deal from falling through. Many sellers, however, actively prefer to do the financing themselves. Doing so not only can increase the chances for a successful sale, but can also be helpful in obtaining the best possible price.
The terms offered by sellers are usually more flexible and more agreeable to the buyer than those offered from a third-party lender. Sellers will typically finance 50 to 60 percent - or more - of the selling price, with an interest rate below current bank rates and with a far longer amortization. The terms will usually have scheduled payments similar to conventional loans. As with buyer-equity financing, seller financing can make the business more attractive and viable to other lenders. In fact, sometimes outside lenders will usually have scheduled payments similar to conventional loans.The Dos and Don’ts of Seller Financing
In today’s tight business-for-sale marketplace, an owner’s willingness to finance the sale gives him or her an edge over the competition. But owner financing isn’t for the faint of heart. To stay on track, sellers need to follow some obvious – and some not so obvious – dos and don’ts.
There’s nothing more frustrating than a listed business that attracts a lot of attention, but no buyers who are willing to seal the deal. Unfortunately, that’s exactly the situation many business owners are facing in today’s marketplace.
Most of the time, the business isn’t the problem. In fact, a business that generates significant attention in the marketplace is usually a good candidate for a sale. Instead, the issue is most often the buyers’ inability to secure financing at the owner’s asking price. That leaves owners with two options: Either lower the asking price or work with the buyer to overcome sale barriers.
Rather than leaving money on the table, many owners are deciding to finance the sale themselves. Is it a gamble? Absolutely, but under the right circumstances it can also be a financial boon. If financing the sale of a seller’s business sounds like a good idea, don’t make another move until you’ve carefully considered the lessons being learned by other seller-financers.
DO Assess the Risk
A cash sale is an essentially risk-free transaction for the seller. Once the deal is done, the seller can comfortably walk away from the business with money in the bank. In an owner-financed transaction, the seller continues to be tied to the business long after the sale is complete. If the business succeeds, the new owner pays back the principal with interest and everyone is happy. But if the new owner is unable to make the business profitable, the seller could suffer the loss of interest income and incur additional costs to collect the debt.
The bottom line is that an owner-financed sale needs to be evaluated as a business investment. Like any other investment, there is a certain amount of risk inherent in the decision. If you are comfortable enough to invest in the new owner, then it could be beneficial for the seller to finance the sale themself. But if you aren’t confident the buyer can make the business a success, offering financing as an enticement to close the deal is the worst decision a seller can make.
DO Leverage the Benefits
If the buyer is, in fact, a good investment risk, the seller stands to reap substantial benefits from self-financing. Too many sellers view financing as a desperate measure to unload the business when they should be viewing it as a resource for enhancing the benefits of the sale.
Right out of the gate, a seller’s willingness to hold paper increases the final selling price of the business. Partially-financed sales typically result in a price that is more than 15 percent higher than their cash sale counterparts. That means you can leverage your seller’s willingness to finance as a bargaining tool during negotiations.
The other big benefit of financing the sale is the potential to multiply the principal value of the business through future interest payments. As you might expect, a financed sale garners a much higher rate of return than many other investment vehicles with a five to seven year note at 8 to 10 percent interest as the norm. Don’t succumb to a buyer’s pleas of poverty. Remain firm on charging the amount of interest you feel is appropriate for the market and the level of risk you are assuming.
DO Advertise Your Willingness to FinanceSometimes sellers are hesitant to advertise a financing option because they aren’t totally sold on the idea and are only willing to offer financing if they get backed into a corner during the negotiation process.
One of the most productive avenues for advertising a seller-financed company is online. We see that listings containing information about owner financing yield a noticeably higher volume of hits than those that don’t.
DON’T Waive the Down Payment
An owner-financed sale can be a risky venture. However, a healthy down payment can minimize your exposure by distributing an equal or greater amount of the risk to the buyer.
Generally speaking, it’s in a seller’s best interest to finance no more than 1/3 to 2/3 of the sale price. If the seller decides to finance more than that, they need to have a legitimate reason for doing so. For example, if the seller is selling the business to a family member, they may have a vested interest in financing an amount beyond the normal range. Just be aware that as their financing commitment increases, so does your risk.
DON’T Let Your Seller Be Pressured
There’s a good chance that potential buyers will try to push for a seller-financed deal. This is particularly true for buyers that are unable to secure financing from traditional lending sources due to an inadequate down payment or other borrowing obstacles.
No matter how anxious a seller is to sell the business, caving into buyer pressure for the sole purpose of closing the deal is a big mistake. When a buyer pushes too hard for financing, take a step back and conduct a simple reality check. If you aren’t completely comfortable with financing the buyer’s purchase, walk away and wait for a better buyer candidate to emerge.