Corporate downsizing in the U.S. over the last several years has made owning a business more attractive 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 purchase of an established business?
You, as a prospective buyer, are no doubt aware that any credit crunch prevents a traditional lending institution from being the sole solution to your needs. Where then can buyers turn to for help with what is likely to be the largest single investment of their lives? There are a variety of financing sources, and Gatway School Sales can help you find the one or combination of several that best fills your particular requirements. The following routes are what we consider to be the best:
Buyer’s Personal Equity
In most business transaction situations, this is the place to be. Typically, anywhere from 10-30% of cash needed to purchase a business comes from the buyer and their family. You, as the buyer, should decide how much capital you are able to risk. A good rule of thumb is being prepared to come up with 20-30% of the purchase price.
Buying a business by means of a highly-leveraged transaction (one requiring minimum cash) is not a reality for most buyers. The exceptions that prove this rule are those buyers with special talents or skills sought after by investors, those whose business will directly benefit jobs of local public interest, or those whose businesses are expected to make unusually large profits. If you don’t fall into one of these broad categories, using personal equity to finance a purchase is probably going to be required.
Personal equity financing is a good starting point because buyers who invest their own capital are creating an example for others. If you invest your money, you are positively influencing other possible investors or lenders to participate.
One of the simplest ways to finance the acquisition of a business is to work hand-in-hand with the seller. The seller’s willingess to participate will be influenced by their own tax considerations as well as cash needs, but a seller’s willingness to finance part of the purchase shows their confidence in the strength of the business.
In instances where the business financial statements have a great deal of “owner benefit” in the expense lines, sellers almost have to finance the sale of their own business in order to keep the deal from falling through. Some sellers, though, actually prefer to do the financing themselves. Doing so not only has the potential to increase the chances of a successful sale, but can also help obtain the best possible price.
Terms offered by sellers are more often flexible and more agreeable to buyers than those from a third-party lender. When seller financing is offered, it typically covers 30-50% —sometimes 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, but the tax picture can be better than with straight debt.
As with buyer equity financing, selling financing can make a business more attractive and viable to other lenders. In fact, sometimes outside lenders will refuse to participate unless a large chunk of seller financing is already in place.
Venture capitalists have become more and more eager to play a part in the financing of independent businesses. Previously known for exclusively pursuing the high-risk, high-profile, startup opportunities, they are becoming increasingly interested in established, existing entities.
This does not mean that outside equity investors are going to be lining up outside your door, especially if you would expect a single investor to take on this kind of risk. Professional venture capitalists are less likely to consider the risk daunting, but they will likely want majority control and will expect at least a 30% annual rate if return on their investment.
Outside venture capital is an option to consider when purchasing a business, but it should not be the only option.
Small Business Administration
Thanks to the U.S. Small Business Administration (SBA) Loan Guarantee Program, favorable financing terms are available to prospective business buyers. SBA loans have long amortization periods, with up to ten years if no real estate is included, up to 25 years if real estate is included, and up to 90% financing of the purchase price.
SBA loans are not a given though. You, as the buyer seeking a 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 ensure that loan payments can be made. If there is adequate cash flowbut insufficient collateral, you may have to offer personal collateral, such as non-homestead real estate or other personal property. A personal guarantee will also be required by the lender.
The SBA has become more in tune with small business financing over the years. It now offers a Lo-Doc program for loans under $100,000 that requires only a small amount of paperwork. More and more banks are also being approved as SBA lenders. To learn more about what the Small Business Administration may be able to offer, visit their website.
Conventional Lending Institutions
Banks and other lending institutions provide unsecured loans commensurate with the cash available for servicing the debt. “Unsecured” is a bit of a misnomer because banks and other lenders of this type will aim to secure their loans if the collateral exists. If you are seeking a bank loan, you will find more success if you have a large net worth, liquid assets, or a reliable source of income. Unsecured loans are also easier to come by if you are already a favored customer with the institution or if you qualify for the SBA loan program.
When a conventional bank participates in the financing of a business transaction, it will typically finance 50-75% of the real estate value, 75-90% of new equipment value, or 50% of inventory. The only intangible assets banks are likely to finance are accounts receivable, which they will finance from 80-90%.
Although the terms may sound attractive, you would be unwise to look toward conventional lending institutions to finance the acquisition. By some estimates, over 80% of business acquisition loans are rejected by banks.
A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies, mezzanine financing is basically debt capital that gives the lender the right to convert to an ownership or equity interest in the company if the loan is not paid back in full on time. It is generally subordinated to debt provided by senior lenders such as banks and venture capitalists.
Since mezzanine financing is usually provided to a borrower very quickly with little due diligence on the part of the lender and with little or no collateral on the part of the borrower, this type of financing is aggressively priced, with the lender typically seeking a return of 20-30%.
This type of financing is advantageous because it is treated as equity on a company’s balance sheet and may make it easier to obtain standard bank financing. To receive mezzanine financing, a company must demonstrate a track record in the industry with an established reputation and product, a history in the profitability, and a viable plan for expansion for the business.
With any of these options, though, you must be open to creative solutions and taking some risks. Whether the method finally chosen is personal, seller, third-party financing, or a combination of several methods, you should feel confident that there is a solution to the financing of your purchase