Financing the Business Purchase

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Where can buyers turn for help with what is likely to be the largest single investment of their lives? For most small to mid-sized business acquisitions, here are the best ways to go:

Personal Equity

Typically, anywhere from 20 to 50 percent of cash needed to buy a business comes from the buyer and his or her family. Buyers who invest their own capital (usually an amount between $50,000 and $150,000) are positively influencing other investors or lenders to participate in financing.

Seller Financing

This is one of the simplest and best ways to finance the acquisition, with sellers financing 50 to 60 percent–or more–of the selling price, with an interest rate below current bank rates, and with a far longer amortization. Many sellers actively prefer to do the financing themselves, thereby increasing the chances for a successful sale and the best possible price.

Venture Capital

Venture capitalists are becoming increasingly interested in established, existing entities, although this type of financing is usually supplied only to larger businesses or startups with top management and a good upside potential. They will likely want majority control, will want to cash out in three to five years, and will expect to make at least 30 percent annual rate of return on their investment.

Small Business Administration

Similar to the terms of typical seller financing, SBA loans have long amortization periods. The buyer must provide strong proof of stability–and, if necessary, personal collateral, but SBA loans are becoming more popular and more “user friendly.”

Lending Institutions

Those seeking bank loans will have more success if they have a large net worth, liquid assets, or a reliable source of income. Although the terms are often attractive, the rate of rejection by banks for business acquisition loans can go higher than 80 percent.

Source of Small Business Financing (figures are approximate)

Commercial bank loans 37%
Earnings of business  27%
Credit cards  25%
Private loans  21%
Vendor credit  15%
Personal bank loans 13%
Leasing  10%
SBA-guaranteed loans 3%
Private stock  0.5%
Other 5%

Financing the Business Acquisition

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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:

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.

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.

Venture Capital

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.

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.

Friends and Family: A Financing Option

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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 Financing: The Hard Facts

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Government financing and venture capital financing account for less than one percent of all new business financing. Sixty-seven percent of all small to mid-sized businesses are financed by personal savings or friends; thirty-three percent are financed by lending institutions. The facts about venture capital financing are especially cold and hard…

  • Venture capital is limited to high-growth potential, high capital-absorbing businesses.
  • Venture capital benefits as few as 1000 businesses a year, and then…
  • The average investment is $2.3 million, divided between 3-4 venture capital funds, which take 40-50-60 percent or more of the business’s equity.
  • Venture capital investors expect the business to grow to $25-50 million within 5 years–at which time the business will go public or be sold.

Negotiating the Price Gap Between Buyers and Sellers

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Sellers generally desire all-cash transactions; however, oftentimes partial seller financing is necessary in typical middle market company transactions. Furthermore, sellers who demand all-cash deals typically receive a lower purchase price than they would have if the deal were structured differently.

Although buyers may be able to pay all-cash at closing, they often want to structure a deal where the seller has left some portion of the price on the table, either in the form of a note or an earnout. Deferring some of the owner’s remuneration from the transaction will provide leverage in the event that the owner has misrepresented the business. An earnout is a mechanism to provide payment based on future performance. Acquirers like to suggest that, if the business is as it is represented, there should be no problem with this type of payout. The owner’s retort is that he or she knows the business is sound under his or her management, but does not know whether the buyer will be as successful in operating the business.

Moreover, the owner has taken the business risk while owning the business; why would he or she continue to be at risk with someone else at the helm? Nevertheless, there are circumstances in which an earnout can be quite useful in recognizing full value and consummating a transaction. For example, suppose that a company had spent three years and vast sums developing a new product and had just launched the product at the time of a sale. A certain value could be arrived at for the current business, and an earnout could be structured to compensate the owner for the effort and expense of developing the new product if and when the sales of the new product materialize. Under this scenario everyone wins.

The terms of the deal are extremely important to both parties involved in the transaction. Many times the buyers and sellers, and their advisors, are in agreement with all the terms of the transaction, except for the price. Although the variance on price may seem to be a “deal killer,” the price gap can often be resolved so that both parties can move forward to complete the transaction.

Listed below are some suggestions on how to bridge the price gap.

  • If the real estate was originally included in the deal, the seller may chose to rent the premise to the acquirer rather than sell it outright. This will decrease the price of the transaction by the value of the real estate. The buyer might also choose to pay a higher rent in order to decrease the “goodwill” portion of the sale. The seller may choose to retain title to certain machinery and equipment and lease it back to the buyer.
  • The purchaser can acquire less than 100% of the company initially and have the option to buy the remaining interest in the future. For example, a buyer could purchase 70% of the seller’s stock with an option to acquire an additional 10% a year for three years based on a predetermined formula. The seller will enjoy 30% of the profits plus a multiple of the earnings at the end of the period. The buyer will be able to complete the transaction in a two-step process, making the purchase easier to accomplish. The seller may also have a “put” which will force the buyer to purchase the remaining 30% at some future date.
  • A subsidiary can be created for the fastest growing portion of the business being acquired. The buyer and seller can then share 50/50 in the part of the business that was “spun-off” until the original transaction is paid off.
  • A royalty can be structured based on revenue, gross margins, EBIT, or EBITDA. This is usually easier to structure than an earnout.
  • Certain assets, such as automobiles or non-business-related real estate, can be carved out of the sale to reduce the actual purchase price.

Although the above suggestions will not solve all of the pricing gap problems, they may lead the participants in the necessary direction to resolve them. The ability to structure successful transactions that satisfy both buyer and seller requires an immense amount of time, skill, experience and most of all – imagination.

Key Items Necessary for Selling a Business

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  • Three years of profit and loss statements
  • Federal taxes for the same three years
  • Current list of fixtures and equipment
  • The lease and related documents
  • Franchise agreement (if applicable)
  • List of encumbrances, loans, equipment leases, etc.
  • Approximate amount of inventory on hand
  • Names of outside advisors with contact information
  • Marketing materials, catalogs, promotional pieces, etc.
  • Operations Manual (if available)
  • Brief history of business

What Makes a Business Unique

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Most business owners think that their business is unique. There are obviously many different attributes that can make a business stand out from others. However, there are some key factors that make a business both unique and, at the same time, make it more valuable in the marketplace and more desirable by prospective purchasers. Just as importantly, these unique factors also need to be generally transferable to a new owner. Here are some key ones:

Intangible Assets
One example of an intangible asset could be a long-term lease for a great location that is transferable to a new owner. Other examples include a mailing list of current and past customers, a popular franchise relationship, a well-known product line such as Hallmark, or a well-established mailing program designed to attract new customers or clients. Trademarks and copyrights are some other examples of intangible assets.

Difficulty of Replication
For example, in most jurisdictions, liquor licenses are doled out by population or on some other limited basis. One can not just decide to rent some space and open a liquor store. Franchises often limit the number of units in a geographical area. Selling certain brand collectibles is a license not granted to just any store.

Proprietary Products, Services or Technology
A business owner may have developed, or have had developed, software unique to their business which is a key to its success. Or the proprietary item could be something as simple as a secret recipe for a food item, sauce or other food product unique to a restaurant.

Reputation
There is the pharmacy that is known all over town for delivering prescriptions or other medical needs. And there is the hardware store that will still sharpen knives or fix screens. Then there are the local businesses that have “just what you need” or that special something that makes them known all over town. While these characteristics make these businesses unique, it is up to a new owner to continue them.

When looking at businesses to buy, buyers should look beyond the numbers for the unique qualities that separate a particular business from the pack.

Are You Serious?

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There are three good questions to consider before selling your business.

First, “Do you really want to sell this business?” If you’re really serious about selling and have a solid reason (or reasons) why you want to sell, it will most likely happen.

Second, “Do you have reasonable expectations?” You increase your chances of selling if you can answer “yes” to this second question. This can include your expectations about the selling price, the time it will take to sell your business, and the amount of seller financing you are willing to offer.

Third, “What will you do once your business sells?” The time to consider this is before you place your business on the market. This may seem obvious, but many transactions fall through because the business owner did not consider what he or she would do once the business was sold.

A “yes” answer to the first two questions plus having an answer to the third question (other than “I don’t know”) means you are serious about selling.

Selling Your Business? Do-It-Yourself is Risky Business!

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When the owner of a business makes the decision to sell, he or she is taking a giant step that involves the emotions as well as the marketplace, each with its own set of complexities. Those sellers who are tempted to undertake the transaction on their own should understand both the process and the emotional environment that this process is set against. The steps outlined below are just some of the items for a successful sale. While these might seem daunting to the do-it-yourselfer, by engaging the help of a business intermediary, the seller can feel confident about what is often one of the major decisions of a lifetime.

1. Set the stage.
What kind of impression will the business make on prospective buyers? The seller may be happy with a weathered sign (the rustic look) or weeds poking up through the pavement (the natural look), but the buyer might only think, “What a mess!” Equally problematic can be improvements planned by the seller that appeal to his or her sense of aesthetics but that will, in fact, do nothing to benefit the sale. Instead of guessing what might make a difference and what might not, sellers would be wise to seek the advice of a business broker–a professional with experience in dealing regularly with buyers and with an eye experienced in properly setting the business scene.

2. Get the record(s) straight.
Although outward appearance does count, what’s inside the books is even more important. Ultimately, a business will sell according to the numbers. The business broker can offer the seller invaluable assistance in the presentation of the financials.

3. Weigh price against value.
All sellers naturally want to get the best possible price for their business. However, they also need to be realistic. To determine the best price, a business broker will use industry-tested pricing techniques that include ratios based on sales of similar businesses, as well as historical data on the type of business for sale.

4. Market professionally.
Engaging the services of a business broker is the key to the successful marketing of a business. The business broker will prepare a marketing strategy and offer advice about essential marketing tools–everything from a business description to media advertising. Through their professional networks and access to data on prospective buyers, business brokers can get the word out about the business far more effectively than any owner could manage on an individual basis.

What Sellers Can Do

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In addition to using a business broker, there are specific steps you can take to increase the chance of a successful closing.

Know why you want to sell your business. Before placing your business for sale, it is important that you both know why you want to sell your business and that you are certain about this decision.

Have a plan for what you will do following the closing.

Make sure important parties are on board. The time to discuss the sale of your business, as well as future plans, with partners, spouses, children and other involved parties is before you list.

Communicate to your outside advisors that you want the deal to work.

Choose your battles. Both buyers and sellers need to be willing to compromise. It is helpful to consider in advance the areas that are most important to you so you can come to the table with a willingness to compromise in other areas.