BUYING A SMALL BUSINESS

How to Finance an Acquisition

The credit crunch has led to an increase in seller financing, asset-based lending and alternative sources of capital for buyers.
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In pursuing an acquisition there are always key items to consider such as the continued growth opportunity provided by the target company, purchase price, and financing terms. Many acquisitions fail due to these priorities not being in line, say M&A experts. For instance, a common mistake buyers make is to focus on an attractive purchase price, rather than the strategic importance of the company's present and future growth plans.

Securing capital and the best financing terms for an acquisition can be daunting and challenging. The sub-prime lending crisis and sluggish economy over the past 24 months has created huge changes in our financial system. Many traditional lenders have modified their lending criteria, thus restricting available credit and the flow of capital to many entrepreneurs, says Michael Fekkes, a Certified Business Intermediary and senior broker at Enlign Business Brokers in Nashville.

In a million dollar transaction, the buyer would be expected to have a 10 percent down payment, or possibly more depending on the industry. The seller would hold an additional 10 percent in seller financing, and the lending institution would offer a combination of conventional or SBA financing to cover the 80 percent balance of the purchase price, depending on the eligible collateral.

Now buyers are seeing the total transaction value self financed by 20 percent, seller financed by around 30 percent and bank financing is at or even less than 50 percent for the rest of the purchase price, says Anthony S. Hussain, managing partner and founder of Miami-based Capvesco, a capital advisory firm. "Lenders have really asked for more equity in terms of the transaction by the buyer and more notes being held by the seller." Also, because of the credit crunch there are a lot of alternative financing sources that have surfaced. Private lenders are coming to the forefront with the cost of capital higher than the traditional bank loan, adds Hussain. 

Despite current economic conditions, there still remain numerous funding sources to raise capital for the acquisition of an established company, says Fekkes. "Each lender or source of capital will have its own unique and frequently modified criteria for financing, so it will be necessary for the buyer to spend adequate time to properly research and explore all options to determine which source is appropriate and available for their specific business opportunity."

A key to the type and availability of funding is the structure of the company that is being acquired. "A company with little debt, significant assets, and strong cash flow is a good candidate for an acquisition with a significant portion of long-term debt financing," notes Andrew J. Sherman, author of Mergers and Acquisitions from A to Z, and a partner at the law firm Jones Day in Washington, DC.

Acquisitions often involve different layers of capital which could include bank financing, mezzanine financing and private equity. The type of business being acquired, the valuation of assets and cash flow, perceived market risk as well as growth plans, are the characteristics that determine which capital sources and financing structure is the most appropriate, says Hussain. Each type of transaction will have its unique set of evaluation criteria, cost of capital, expectations, deal terms, and covenants.

How to Finance an Acquisition: Bank Financing

If the target company has a lot of assets, positive cash flow and strong profit margin, the buyer should be able to find bank financing. But say you want to buy a service company that has a lot of receivables and short-term assets, the level of difficulty of securing bank financing increases, say industry experts. Recent studies show a significant decline in cash flow-based loans. Quality of cash flow, debt load, and insufficient collateral were cited as primary reasons. Collateral type is emerging as the most important factor in a lender's decision to approve a loan.

"In today's more austere credit market, a buyer has to have good credit scores and assets. There are very few unsecured loans being made," says Fekkes. "It is either going to be secured by the company's assets, cash flow, and/or the buyer's own personal assets."

The Small Business Jobs Act of 2010 changed some of the lending limits for Small Business Administration (SBA) loans. The limit for the SBA 7(a) loan program has increased from $2 million to $5 million. For mainstream businesses (under $5 million) SBA financing remains a viable avenue for buyers.

To help improve your chances, find a bank that has a history of financing the type of business you are buying. If the seller has a strong relationship, then talk to seller's banker. Talk to a number of banks in order to secure financing, suggests Fekkes. "What most buyers or prospective borrowers don't understand is that each bank's requirements are different." So, you may go to one bank and get turned down for a convention loan or SBA financing. You are left with the impression that you don't qualify for a loan. But that could be further from the truth, Fekkes explains.

He recommends as a resource Diamond Financial Services, which structures and packages loans, working with over 100 banks and non-banks that do SBA lending. "They know which banks are lending for which types of loans."

Dig Deeper: How to Choose the Right Bank for Your Small Business

How to Finance an Acquisition: Seller Financing

For small and middle-market transactions, it is quite common for the seller to finance part of the transaction. The simplest way to provide seller financing is for the buyer to make a down payment and for the seller to carry a promissory note for the rest of the purchase price, says Sherman. The business itself and the significant business assets provide the primary collateral for the note.

The terms (interest rates, length, principal payments, and so on) will vary depending on the negotiated agreement. For a business that sells for $500,000, for example, the transaction might be structured as $150,000 down from the buyer and $350,000 in seller financing. The seller note might run for five to seven years and carry an interest rate of 8 percent to 10 percent. Monthly payments usually start 30 days from the date of sale.

Dig Deeper: Financing When Buying a Business



How to Finance an Acquisition: Asset-based Financing

Asset-based lending has become an increasingly popular source of financing. According to the Commercial Finance Association, new credit commitments of asset-based lenders rose by 49 percent in the second quarter of 2010. Asset-based loans are revolving loans secured by the available collateral, such as inventory, accounts receivable, equipment, and fixed assets. The amount that can be borrowed is typically between 65 percent and 80 percent of the asset class.

The primary difference between asset-based lending and traditional lending is what the lender looks to when underwriting a loan, says Sherman. A traditional lender will look first to the cash flow then to collateral. An asset-based lender looks to collateral first, debt load, and quality of earnings. The main drawback of using asset-based loans for financing is the expense involved. Pricing among asset-based lenders is competitive, but interest rates can range from 12 percent up to 28 percent.

Dig Deeper: How to Find Alternatives to Bank Financing

How to Finance an Acquisition: Equity Financing

Equity financing involves the offer and sale of the buyer's securities for the purpose of raising the capital to pay the seller and to provide working capital for the new company. Typically the buyer seeks equity from such sources as private equity firms, venture capitalists, and angel investors.

Right now, most private equity firms are only interested in deals that have $2 million of earnings, generally $10 million dollars in revenues or above, Fekkes says. They are looking at middle market companies versus smaller mainstream companies. The owner has to be willing to give up a significant amount of control of the company, possibly as much as a 51 percent majority stake, he says. So, as a buyer you won't have any debt but you are going to have to give up equity for a cash infusion.

Also, private equity firms are expecting a rate of return of 25 percent. Each will have a different exit strategy and expectation, but in general they are looking to sell the business or take the business public in three to seven years.

Dig Deeper: How Private Equity Shops for Acquisitions

How to Finance an Acquisition: Mezzanine Financing

Mezzanine Financing is a hybrid of debt and equity financing. A mezzanine deal involves a number of technical terms: senior and subordinated debt, private-placement transactions and equity investment. Senior debt refers to loans from sources such as banks and secured by liens on specific corporate assets, for example, property or equipment. Equity is usually in the form for preferred stock. As a buyer, you won't have to give up as much control; it will look more like 20 percent ownership of the price of the target company, says Ronald A. Kahn, managing director of Lincoln International, an M&A advisory firm headquartered in Chicago. He notes that quite a few mezzanine groups have been sponsored by the SBA.

The size of the mezzanine finance industry has grown over the past year and is the only private capital market that is expected to increase in size, according to the "Private Capital Markets Project," conducted by the Pepperdine University Graziadio School of Business and Management. Deals that contain both interest rates and stock ownership return elements have increased 70 percent.

To get the best possible financing terms and improve the likelihood of success in any deal structure, make sure your offering memorandum or business plan is well thought out, says Kahn. "First impressions still count a great deal." Your plan should be based on the combined business not just the current business. It should illustrate how the combined operations will provide more collateral, more cash flow, and greater growth.

Going to a broader audience is really key to getting the acquisition deal done and at the best price, Kahn says. "When we do a placement it is not uncommon for us to submit an offering to 30 or 40 different lenders." He suggests as practical resources the Turn Around Management Association and the Association for Corporate Growth.

Dig Deeper: More on Mezzanine Financing

Last updated: Jan 20, 2011




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