How To: Price and Finance a Business Purchase

This guide details what you need to know about sources of financing, getting pre-qualified, negotiating the price of the business you want to buy, and more.

As strange as it might sound, you should be working to secure your lines of financing before you've even finalized your short list of potential acquisitions, let alone agree upon a price. But wait, you ask, where is the money to finance the deal going to come from? Most folks, many of whom might have turned to things like a home equity loan in the past to finance their acquisitions, figure they can't land the necessary financing these days given the collapse of the housing market and the tightening of the credit market.

Some of these naysayers are correct, says Mike West, managing partner of NorthShore Capital Advisors, a business advisory firm based in Knoxville, Tennessee. The biggest strike against potential borrowers is if their skills don't translate well towards running the business they want to buy. "Anyone expecting to land a loan by walking into their local commercial bank hoping to secure a government-backed small business loan better be ready to sell their skills as an entrepreneur," West says.

The pages that follow detail what you need to know about sources of financing, getting pre-qualified, what you need in terms of collateral and negotiating the price of the business you want to buy.

Sources of Financing

Types of Funding

When buying a business, there are primarily two different sources of financing you can pursue.

Debt financing: To go into debt means to borrow money from an outside source -- most often a bank -- with an agreement to repay the loan principle and usually a certain agreed-upon rate of return, or interest. You can also arrange for private debt financing from friends or family, in the form of loans. Many banks have been reluctant to provide long-term loans to small businesses, and that's why the Small Business Administration offers guarantees to encourage banks to make longer terms loans by lowering their risk.

Equity financing: Instead of taking out loans, you can in essence agree to sell stock or shares of your business to outside investors, sometimes venture capitalists. This is different than a loan in that you don't have to focus on repaying the debt, but you are giving up partial ownership and, in some cases, control.

Getting Pre-qualified for a Loan

Getting pre-qualified for financing often means going to a bank or other lender and obtaining a letter of pre-qualification for a loan. In order to get pre-qualified, you often need to provide information on the business you want to purchase, your collateral, and how you'll be able to repay the loan. Here are some pointers to keep in mind when getting pre-qualified:

• Get approved by as many sources as you possibly can in case, by the time you close on the sale, a bank's lending requirements have changed.
• When thinking about financing the purchase of your new business, you may need to borrow more than the actual selling price of the business.
• If today's economic conditions threaten the continued profitability of the business, you'll need to have a contingency plan in case the cash flow drops to a point where it can just barely cover your debt payments.
• A good rule of thumb is to aim for adding an additional 90 days of working capital (current assets -- current liabilities).

 

Bringing Collateral to the Table

When thinking about landing financing, also consider what you will bring to the table as collateral -- something that might need to be as high as 50 to 70 percent of the selling price for any kind of debt financing, says Art Concha, senior vice president of Americas United Bank, a commercial lender in Los Angeles. Collateral can include any of the following:

• Anything from the accounts receivable of the business to its machinery and inventory.
• Equity in your personal home (if you're lucky enough to have any) or a second or third mortgage on your home. With today's real estate market, though, these options have become less attractive to many lenders who generally prefer to deal with assets they could quickly convert into cash.
• If you are forced to come up with a personal guarantee to secure a loan, your goal should be to make it half the amount of collateral needed.

 

Seller Financing Is a Possibility

Given how important the assets of a business are, the best financing game in town these days is obtaining your financing directly from the seller, says Andy Louis-Charles, head of Landist Capital Management, an investment firm in Raleigh, North Carolina. This basically means the seller is typically willing to wait from three to five years to be paid off. It's an option that has both its benefits and its drawbacks.

Drawbacks: On the downside, seller financing can add anywhere from 5 to 25 percent to the asking price because seller's will typically lend at higher rates than a bank would. However, not all sellers have the ability to wait for their payday.

Benefits: At the same time, since the seller continues to have some skin in the game, the buyer is obtaining a degree of security that the seller continues to have an incentive in having the business perform well and grow. Borrowing from the seller also creates more negotiating opportunities for the buyer than they would ordinarily have with say, a bank. You might be able to stretch out your payments to something like 10 years to keep your payments smaller or you could even offer the seller equity in the business, where they would begin to recoup their selling price through the continued profitability of the business.

Other Sources of Financing