Many business acquisitions require that the purchase price is financed. The idea of financing a business is a way to leverage the money that you have available versus paying all cash for a business opportunity. This means that you may be able to buy a business that is larger in size. Usually larger businesses generate higher seller’s discretionary earnings. Below are a few ways that businesses are financed:
Bank Financing – Financing a business through the bank is one option for business buyers. However, lenders highly scrutinize the business financials, the buyer’s experience, the business and buyer’s collateral and the buyer’s business plan. Financing a business through a bank is not as easy as applying for a car or home loan. Conventional loans usually are not available so a bank may require that the Small Business Administration (SBA) is involved to guarantee a portion of the loan. SBA financing allows lenders to take on additional risk that they may not on their own. However, this extra guarantee for a bank comes at a cost which is normally passed on to the buyer. Recently however, some of the SBA fees have been waived as part of the American Recovery Act. From a lender’s perspective, if an SBA guaranteed loan goes into default, the SBA will pay the lender a percentage of any deficit left after liquidating the assets that were the collateral for the loan.
It is also important to note that when financing a business, not all lenders will view the business the same way. If one lender rejects the deal, it does not necessarily mean the deal cannot get financed through a bank. Some lenders are risk adverse and do not finance businesses in specific industries while others are more aggressive. Collateral, buyer’s experience, and buyer’s down payment may differ from lender to lender. They typically apply a debt service ratio to the stated cash flow which means they want to make sure that there is a cushion to weather the storm during economic times when the business may not earn as much as the past.
It is important that you identify the right individual within the bank that is familiar with business acquisition loans. The current bank of the business owner may be one option to explore since they are familiar with the history of the business. It typically makes sense to explore several lenders at the same time. This is an area that a business broker who works on transactions regularly can assist the business buyer. Business brokers usually have bank contacts that review deals.
Seller Financing – Financing a business with seller financing is becoming more and more important. Banks are more comfortable with the transactions that have a portion of the purchase price in the form of seller financing since they know they have a seller who has a vested interest in the continued success of the business. Sometimes seller financing is in the form of taking back a second note behind the lender that is in first position. The most common option for seller financing involves secured notes, but other options also exist such as unsecured notes, assumption of capital leases, a real estate lease, notes on capital equipment and more.
Business owners who are willing and able to seller finance almost always have quicker sales since there are more options for buyers to purchase the business. Structured right, it can also be tax advantageous for the seller by spreading out some of the proceeds from the business sale. Sellers can put in place requirements to see updated financials from the buyer during the length of the loan just as a bank would require.
It is a lot easier for a business seller to step into the business and take the business back if no other lenders are part of the transaction. In the case that the seller receives the business back because the buyer fails to make the scheduled payments, the business seller will keep the down payment and payments they have received and will be able to keep the business or resell it to another party.
Financing a business using seller financing usually requires a length between three and ten years with an agreed upon interest rate. Sometimes a balloon payment may be part of the equation.
Buyer’s Rainy Day Money – Buyers are increasingly turning to their retirement accounts as a source to purchase a business. Most individuals believe that the only way that they can use their 401k money is by withdrawing their money early and be subject to a 10% early withdrawal penalty as well as have to claim the money as personal income and be subject to additional tax. In other words, a person could see the amount that they thought they had available to purchase a business cut in half.
Many don’t know that, there is a method to buying a business using 401k or IRA money without being subject to these early withdrawal taxes. The high level explanation of the process is that you are buying stock in your own company. There is a lot of legal work to set up this structure, but those that do the math will see that the tax savings can be well worth the effort and set-up expense. We have completed a large number of businesses for sale transactions using this process. Though relatively unknown, it has been a way to buy a business for years. It is just not a well know method by those not buying and selling a business on a regular basis. The appeal to this method is that you are investing in yourself. Though some may say that you are risking your retirement, an argument can be made that it is far more risky investing in the stock market in companies that you have virtually no control. We call it “rainy day money” since if you are out of a job and need a source of income – it’s raining. There are a couple companies that can structure the legal documents. The two most experienced companies that perform this service are shown below. Click on the ads and complete the form to receive more information.
Earnouts – Earnout financing involves a certain dollar amount agreed on by the buyer and seller to be paid to the seller based on the performance of the company after the transaction is completed. Earnouts can be structured in a variety of ways and can be based on different financial benchmarks such as a company's revenues or gross profits.
Financing a business using this method is often the solution for companies that are purchasing on potential rather than recent earnings. It is also used in turnaround situations. Earnouts are also a great solution to bridge a gap in negotiations when the buyer and seller are at a standstill in price that they are willing to buy and sell.
Mezzanine Financing - Mezzanine financing is another alternative for a buyer looking for capital. This is more prevalent in larger merger and acquisition situations versus main street transactions. This type of financing may include interest rates as high as 20 to 30 percent. These lenders expect a large return on their investment for the risk that they take. They lend in a position behind the bank and seller financing. Mezzanine financing is often used in funding goodwill in a transaction that is beyond the SBA loan size limits.