Have you found the “perfect” business to acquire and make your own? Even before coming to terms through a Letter of Intent (LOI) on a targeted acquisition, consideration for how to finance the transaction must be given; a failure of many buyers whom provide an LOI before taking into consideration financing the acquisition.
We will lay out five primary ways to finance a business acquisition for small to lower-mid-market businesses. Additionally, we will highlight why planning for the financing component before issuing an LOI is crucial.
Let’s explore the five primary methods to financing a small business acquisition. No single method needs to be considered in isolation. Instead, a potential purchaser should consider all the relevant methods and determine the best path forward for their unique circumstances. It is important to note that most small business acquisitions are structured utilizing a combination of multiple financing methods.
- Your Own Funds
If you have the available funds including savings, retirement accounts, home equity, or other liquid investments, you may consider the “all cash” purchase method. As with any major purchase, the buyer must assess the alternative uses of such funds and determine whether they can sustain the lifestyle as well as meet their current and future obligations should they deplete these resources fully, substantially, or partially.
It is an uncommon practice for even small businesses (up to $10M) to be acquired for cash only. Most buyers will use their funds in conjunction with seller financing, a business loan, or loans from family, friends or partner(s).
- Loans from Family or Friends
We do see loans from parents, other family members, and friends in start-ups as well as business acquisitions. These tend to be for the purchase of businesses on the smaller size. While this method has its advantages (i.e., quick access to cash, faith in your capabilities, etc.), mixing money with family and friends has the opportunity to damage relationships.
When considering taking a loan from a family member or friend, it is important to seek legal guidance to ensure that all parties are fully aware of, and in acceptance of, the terms of the loan. In addition, the loan must be developed in accordance with regulations including, but not limited to, IRS requirements, and legal entity and state regulations.
- Partner(s) or “Angel” Investors
Maybe the idea of owning the business without complimentary skills and financial resources leads you to consider bringing in a partner or partners. You may have people within your network that can provide value to the transaction whether through financial resources, skill set / experience, connections, or other contributions. It will be crucial for you to seek legal guidance to properly develop the operating agreement and ensure each partner clearly understands the ownership split, responsibilities, and decision making authority.
Another alternative, angel investors, are typically wealthy individuals who are looking for opportunities to provide capital to profitable endeavors whereby their return will be substantial. When thinking of approaching an angel investor, your pitch must be extremely solid, even more so than what you would need in your business case for a lending institution. However, keep your pitch to the point. Angel investors value their time as much as they value their financial resources.
- Seller Financing
Another common approach to finance an acquisition is through use of seller financing whereby the seller provides a loan to the buyer. The percentage of the overall purchase that is financed through a seller’s note is often around 10% – 25% for small business acquisitions, although there is great variation highly dependent upon the parties involved and the unique circumstances. The loan is amortized over period of time under terms and conditions mutually agreed upon between you and the seller. While SBA guidelines have changed as of January 2018 (and are subject to change), most banks would like to see that the seller has the confidence in the success of the business going forward to extend seller financing.
The advantages of seller financing include, but are not limited to, not having to meet stringent underwriting requirements, the seller possesses institutional knowledge of the business and its future prospects, potential for greater flexibility in terms and conditions, and a desire to see the business continue to succeed along with strengthening the business case for a lender. There is also an incentive for a seller to ensure a smooth transition and potentially offer on-going training and support, whether formally through a consulting agreement, or informally by way of availability by phone to address a purchaser’s questions.
As addressed in the opening paragraph, considering the financing methods are important before submission of an LOI. In the case that an LOI had been submitted without discussion of seller financing upfront, it may be more difficult for the buyer to negotiate the seller to hold a note. The general outline of the seller financing will also have impact on the financial projections of debt servicing as well as any potential bank financing.
While the seller may not have established underwriting policies or have experience in seller financing, a buyer should keep in mind that the seller wants to know they can trust you to repay them whether from the operations of the business or otherwise. As such, it is important to develop a solid rapport with the seller as well as present your personal financial statements and credit history.
- Bank Loans and SBA Loans
Bank loans for business acquisitions can be broken down into two primary categories:
- Conventional Loans – these loans are difficult to secure from a commercial lending institution to finance a small business acquisition. Conventional lending standards are set to decrease the risk of loss for the lending institution. Therefore, you must be able to demonstrate near flawless credit history, substantial personal assets, and congruent experience within the specific industry. Additionally, the need for collateral (i.e., hard assets that can be sold in the event of default to minimize the lender’s losses) is greater.
- SBA Loans – loans offered through lending institutions where the Small Business Administration (SBA) guarantees a portion of the loan to minimize the lender’s exposure in the case of default by borrower. There are different levels of banks that offer SBA loans with some allowed greater flexibility than others in determining which loans they extend. The most common SBA backed loan is the 7a loan which can provide funding up to $5M for a singular person or business. While these loans account for the majority of small business acquisition loans, it is important for a buyer to understand that the SBA is a governmental authority and, as such, the process may be long and the requirements extensive.
Regardless of the loan, conventional or SBA loan, it is important for the buyer to be able to demonstrate capability to the lender. This will be done through discussions, but will also covered in the Business Case, a subject to be addressed in greater detail in a subsequent article. The “sniff test”, done before submission to the lender, is to have a trusted family member, friend, or business advisor deliberately poke holes in the business case to allow for the buyer to adequately address areas of risk by providing clear mitigation strategies. Last point here is to also build conservative-leaning financial projections. Very few lenders, or any at all, will believe that new ownership will automatically bring double digit growth rates over the next decade.
The use of proper valuation techniques for determining the purchase price is also critical. Take for example, a buyer who offers a purchase price that is 50% greater than an acceptable valuation that a lender will secure from a qualified valuation firm. The buyer’s original combination of own funds and seller financing would be significantly impacted as the lender will not exceed the underwriting standards based on a legitimate valuation. The deal, based on this example, most likely would not close unless the purchase price was reduced significantly, the buyer produced additional funds, or the seller provided greater seller financing.
As seen from above, there are many methods for acquiring a business. The optimal solution varies by buyer and targeted acquisition. To learn more about financing a pending or future transaction, contact P&L Business Brokers, LLC to gain insights from decades of transactions and relationships with qualified lenders.
Additionally, the financing costs associated with the aforementioned small business financing methods include the ongoing repayment over life of the loan, but very likely will include significant closing costs that should be planned for between 10-20% of the purchase price. In some cases, such closing costs may be required to be covered from your own funds or may be rolled into the loan.
In addition to developing a solid estimate of the loan costs, a buyer must also consider the working capital (ongoing cash needs) of the business. Many times, a buyer will forget to properly plan for the working capital needs of the business and will find him/herself with cash flow issues early on. We will cover working capital requirements in a future article.
Editor’s Note:
We make every effort to impart our vast experience and keep up-to-date with the latest small to mid-market business transaction trends and all peripheral topics. We do not, however, guarantee the accuracy of the information above nor the indefinite life of the above information.