What it takes to Buy a Small Business
Expanding your growing enterprise is an exciting proposition but finding financing to help acquire a new business can be a challenge. Add to that a difficult lending market and an increasing seller-funding trend and you may find yourself in unchartered financial waters.
Acquisitions are a different breed than simply expanding your existing business or starting a business from scratch. Similar to buying a second home or investment property, lenders want to see that you have more invested in the business opportunity. Things to consider include: growth opportunity by the prospective company, purchase price, and terms of finance, which if you are asking for seller-funding the transaction may fall heavily onto your shoulders to create a proposal. “Many businesses don’t consider these points carefully enough before they make a deal and are often shocked when the new business doesn’t produce income as quickly as anticipated.
Let’s look at a typical financing scenario as described Carolyn M. Brown’s article, How to finance an Acquisition in Inc.com. “In a million dollar transaction, the buyer would be expected to have 10 percent down payment, or more depending on the industry,” says Brown. The seller would then hold an additional 10 percent in seller financing and the lending institution would offer a combination of conventional or SBA financing to cover the remaining 80 percent balance of the purchase price. With the shift in the lending market, buyers are now seeing transactions that are markedly higher with nearly 20 percent self-financed, 30 percent or more seller financed and the remaining balance bank financed.
Lenders are asking for more and more of the buyer and seller’s own skin in the game, If the business owner doesn’t have the accounting and financial forecasting in line, it becomes nearly impossible for him or her to have the financial backing to make a solid bid.
If you still haven’t found the right financing, don’t despair. There are still multiple funding sources available, if you know where to look.
The structure of the company being acquired is critical to matching the right financing. Look for a business that has:
Strong cash flow
If the business hits the mark on all three areas, then it may be a good candidate for an acquisition.
A review of the acquisition’s valuation, including assets, cash flow, perceived market value, growth plans and market risk all play into the final calculations to determine which type of financing structure is best. There are three primary financing options: Bank financing, mezzanine financing, and private equity
The target company should have strong assets, positive cash flow, and a solid profit margin to qualify for bank financing. Many companies are service-focused and don’t carry the assets and cash flow that banks look for on the P&L statements. Find a lender that specializes in loans for your business type, So many times a business owner will come to us having been turned down for a loan from their regular bank. In reality, there are hundreds of banks and lending options out there if you know where to go. Businesses should look for a financial services firm that can structure and package loans. Organizations like this will often work with hundreds of different banks and lending institutions, all specializing in different business types and loan packages.
Asset Based Financing
Asset based financing typically involves revolving loans secured by the business’ available collateral such as inventory, accounts receivables or equipment/fixed assets. Asset lenders will look to collateral first, debt load and then quality of earnings. Traditional lenders will review cash flow first then collateral. While asset based financing may be the right option for your business, know that there is a higher cost for the loans, often interest rates can range between 12 and 28 percent.
Equity financing takes the offer and sale of the buyer’s securities for the purpose of raising capital. The capital is used to pay the seller and provides additional working funds for the new company. In layman’s terms, the lenders are venture capitalists and angel investors like television Shark Tank’snotorious angel investor ‘shark’, Mark Cuban. Depending how much equity you’re willing to part with, taking on an equity partner like Cuban may or may not be right for you. Angel investors take a vested interest in your business’ operations. It’s a two-way street. Business owners want to utilize the business prowess of successful entrepreneurs, but that guidance comes at a price. Trends today in equity markets typically require deals starting at $2 million of earnings and generally ranging to upward of $10 million in revenue or more. Owner(s) must be willing to give up a significant portion of the company and equity investors are expecting anywhere from 25 to 40 percent rate of return on their investment.
A hybrid of debt and equity financing plans, the Mezzanine financing plan involves the greatest amount of risk for the financer. A loan is made to the owner with terms that “subordinate” the loan to different levels of senior and junior debt.
A new vocabulary: Senior and subordinated debt. Senior debt includes loans from banks and secured liens on specific corporate assets. Subordinated debt includes private-placement transactions and equity investment or preferred stock. Not a source of start-up funding, Mezzanine funding is definitely not for the newbie entrepreneur, but rather for experienced business owners who have experience in navigating financing and equity propositions. Mezzanine financing is also one of the most expensive forms of financing with investors seeking 20 percent and higher of the target ownership. For this larger share, investors are willing to assume significantly deeper debt and risk, often being the last to get paid when something goes wrong.
Whatever financing road you choose, know that the most successful plan is a well-planned journey and a map to lead you down the right course. Having a strong accountant and business financial advisor is step number one.
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