How To: Price and Finance a Business Purchase
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
- Depending on the kind of money you need to borrow, you can attempt borrowing from friends and family members or even angel investors.
- You might even consider your options in rolling over your personal 401(K) plan to finance your purchase without taking a tax hit, says Itamar Chalif, founder of Atlantic Capital Solutions in Middleboro, Massachusetts.
- Once you have purchased the business, you might also be able to tap other sources of capital like factoring companies, which will lend you money against your AR, or even leasing companies which might be willing to buy any equipment you own and lease it back to you, which would generate an infusion of cash for the business.
- Once you have a track record, banks might also be willing to extend you a line of credit.
Sidebar: Spotlight on SBA Financing
These days, given the economy, Tom Burke, senior vice president of SBA lending at Wells Fargo, the nation's largest lender of SBA-backed loans, says he's surprised his bank isn't getting more calls from prospective buyers. "We have a lot of money to lend, but we're seeing some reticence on the part of borrowers," he says. "This is the time people should be looking for government-backed loans."
Here are three tips on how to land an SBA loan of your own:
- Have a business plan. One that includes at least three years of projections. Burke says that it's imperative that you have a plan that outlines why you are planning on buying a business and how you plan to grow it. "While we don't expect you to be a whiz about the numbers right off the bat, be prepared to talk about everything from your marketing plan to which of your family members will be working in the business," he says.
- Clean up your personal credit. Burke suggests that every potential borrower get a copy of their credit report and make sure it's correct. "In today's environment, clean personal credit is an issue when it comes to SBA loans," he says.
- Be prepared to make a down payment. To land a loan from Wells Fargo, Burke says borrowers should be prepared to make a down payment of 15 percent to 20 percent of the selling price. He says this is an area where seller financing is playing a greater role these days.
Negotiating the Price
While you pursue your financing, you and the seller obviously need to come to a mutually agreeable price if you want to move forward and purchase a business. If you've become stuck, your accountant can lend you a hand by helping you understand how much you can actually afford to pay for the business after you account for your debt service and working capital requirements. Here are several factors to keep in mind:
- It's useful to consider who you are negotiating with. Most sellers are of the mindset that, no matter what kind of business they put up foe sale, they will think it's worth more than it actually is, particularly if there is an emotional attachment to this business. If the seller founded the business or it has been a part of his or her family, you as the buyer might find it more difficult to agree on a price. Sellers might also have their own debt to account for, which can have a significant impact on driving up the asking price, says Chad Simmons, author of the Business Valuation Bluebook.
- Protect yourself from the potential pitfalls from a down economy. One way to accomplish that is to tie part of the purchase price to future earnings. These are called performance-based deals or earn outs. Not only does this build some insurance for you as the buyer in case short-term sales take a dip, it also puts the seller in the spot in terms of putting their money where their mouth is. If the business is as great as they say it is, the seller should be willing to bend on this part of the offer, especially if you are at an impasse in the negotiation.
- Be aware of potential complications in negotiations.Sometimes, the back-and-forth of negotiating a price can get complicated for unexpected reasons. For example, back in March 2007, Brian Douglas was close to finalizing a deal to buy a customer cabinet manufacturer based in Los Angeles. Douglas says he spent several months searching for the right opportunity and he was excited about the potential of this one -- which had a strong reputation with home contractors and an Earnings before Interest, Taxes, Depreciation and Amortization (EBIDTA) of about $5 million. The rub was that the company's founder, a master Argentinean craftsman, had recently passed away. That meant that Douglas was negotiating with the founder's widow, who had an emotional attachment to the business her husband had built from scratch. After several months, and five plane trips for Douglas, the deal fell apart because he wasn't willing to pay the asking price and the seller didn't want any kind of a performance-based earn out. "In the end, I thought the asking price was too risky for us to accept," he says.
- Build in conditions to break an impasse.The best advice as breaking an impasse, says Peter Berg, of Transworld Business Brokers in Florida, is to make an offer through a letter of intent (LOI) that is contingent on the seller proving that what they say about the business is true. In other words, build in conditions to your offer that would allow you, as you uncover aspects that make you uncomfortable, to reduce the price or bail out of the deal altogether. If the business stands up to the scrutiny you'll give it during the due diligence phase that comes next, the price will stand. One thing to remember, however, is that under no circumstances should you ever pay the seller any cash prior to the final close. As a show of good faith, you can put a deposit of 10 percent of the selling price into an escrow account instead.
Darren Dahl is a contributing editor at Inc. magazine, which he has written for since 2004. He also works as a collaborative writer and editor and has partnered with several high-profile authors. Dahl lives in Asheville, North Carolina.