Access to capital is often the hurdle that forces optimistic entrepreneurs to abandon or delay their acquisition plans. During the economic downturn experienced during the Great Recession, buyers often relied on seller financing and other funding mechanisms when bank loans weren't available. But now that the economy has rebounded, the financing landscape is shifting in ways that may cause buyers to re-think their acquisition strategies.
How Small Business Acquisition Funding Is Changing
Funding for small business acquisitions typically comes from a combination of sources: buyer equity (savings or funding from friends and family), commercial loans and seller financing.
At BizBuySell.com, we're continuing to see brisk activity in the business-for-sale marketplace. How is this increased transaction activity affecting deal structures and financing methods? According to the IBBA and M&A Source's Q4 2014 Market Pulse Survey Report, several changes have occurred over the last year in the funding mix for small business acquisitions.
As of Q4 2014, seller financing was involved in 14% or less of deal structure for companies worth less than $1MM--in Q4 2013, as much as 17% of deal structure was attributed to seller financing. Seller financing is even less important for larger deals and currently represents only 8% of deal structure for businesses in the $1MM to $2MM range, down from 17% in Q4 2013
One of the primary factors behind the drop in seller financing is improved access to commercial financing. The SBA reported a 12% increase in the number of government-backed loans in 2014, which was a record year for the agency. Since it's easier for buyers to access commercial funding, many sellers are limiting their risk exposure by declining to finance any portion of the sale.
Buyer Equity and Senior Debt
A combination of buyer equity and senior debt is becoming a more common strategy in small business acquisitions. In Q4 2014, buyer equity/senior debt accounted for 85% of deal structure for companies in the $500K to $1MM range and 84% of deal structure for companies valued at $500K or less. This represents a significant increase from Q4 2013 when buyer equity and senior debt represented 72% of deal structure for companies valued at $500K to $1MM and 68% of deal structure for companies worth less than $500K. For even larger deals, at year-end 2014, a combination of buyer equity and senior debt funded 89% of deal structure for companies valued at $1MM to $2MM, compared to 70% in 2013.
The rise in buyer equity and senior debt is predictable, given the increased willingness of commercial banks to finance buyers with a healthy down payment and collateral or SBA backing. But it may also be a sign that lenders are becoming more confident in the economy and the growth potential of small companies. Additionally, a rising stock market, increased property values, growing personal assets, and increase buyer confidence have enabled buyers to take a larger equity stake themselves.
The IBBA and M&A Source's Q4 2014 Market Pulse Survey Report Q4 showed that today's buyers are increasingly relying on 401(k) rollovers to fund small business acquisitions. In Q4 2014, 401(k) rollovers accounted for 9% of deal structure for businesses valued at $500K or less, compared to 5% in Q4 2013. Likewise, 401(k) rollovers were tied to 24% of deal structures for businesses worth $500k to $1MM in 2014, compared to 16% in Q4 2013.
The spike in the use of buyers' 401(k) retirement funds to finance business acquisitions may a symptom of reduced availability of seller financing or a lack of down payments for commercial loans. But the significant increase in 401(k) rollover funding may also be a sign that buyers have a more positive outlook on the small business economy--and are willing to risk retirement savings on their companies' success.
Advice for Small Business Buyers
Although the funding mix for business acquisitions has changed since the recession, buyers' approach to the funding challenge should remain unchanged. Across all categories, personal savings is still the most reliable funding resource and it continues to play a role in buyers' ability to secure financing from lenders.
With opportunities for seller financing diminishing, buyers should also explore SBA 7(a) loan guarantees and other programs that make it easier to secure commercial financing. In some cases, equity and loans from friends and family members may make the difference in sealing the deal.
Finally, 401(k) rollover funding is an option for many buyers. But buyers should carefully consider the benefits and risks of using their retirement savings to fund a business acquisition. Even in booming economies, businesses fail--spelling disaster for entrepreneurs who invest their retirement savings into sinking businesses.