Buyer Financing
Paying for the Business - Buyer Financing
How do buyers pay for Businesses? The best case scenario, from a Seller’s perspective is when a buyer has readily available capital and can make an all cash purchase strictly based on their own decision making and capital. That is the best case but is not the only way businesses are purchased. Oftentimes the Buyer will not have the entire purchase price in cash or does not want to tie up all of their available capital in an all cash deal. If a Buyer can obtain reasonable financing where the cost of capital is manageable, the Buyer can earn an even greater return on the money they do have invested. The interest paid on debt is also deductible by the business, similar to mortgage interest being deductible on a home purchase.
In many cases, access to the required capital for the purchase of a business may materialize in the manner of a business acquisition loan. These loans can come from a variety of sources and finding the correct source for you is essential; for financing your business purchase in the most advantageous manner to you can be critical to the early success of the opportunity.
Businesses are often purchased with a combination of Cash plus traditional financing or debt, or by Cash plus seller financing or by Cash plus Equity Investment. Cash plus Equity Investment is having partners come into the deal for a percentage of ownership of the business.
Types of Purchases:
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100% Cash at Closing
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Cash + Traditional Debt Financing (Bank Financing)
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Cash + Seller Financing
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Cash + Equity Investment by Third parties
All Cash Purchases
The all cash purchase is often best for the Buyer and the Seller of a Business. If the deal is all cash, the Buyer is a stable purchaser that doesn’t have to address concerns by partners, bankers or governmental regulations. Not having additional parties to satisfy speeds along the process. All cash buyers can often get a better price on businesses as the Seller’s can see that the closing will be faster and more certain. An offer on a home is best as all cash-no financing contingency, the same applies to Businesses. Not having to go through asset appraisals, bank loan committees or jumping through regulations for an SBA loan is attractive to both buyers and sellers.
Cash Plus Debt Financing
One of the most common ways to finance the purchase is to get a business acquisition loan, and financing the purchase by taking on a substantial amount of debt. These type of loans can be found through companies that either specialize in financing business acquisitions for our market or through a local bank. Sourcing the loan and taking on debt is an important aspect of purchasing a business….here are a couple of things to consider.
When debt is taken on to acquire the business, the lender is not an owner of the business. Thus, it allows the sole owner to have total control on how the proceeds from the loan are best utilized. That being said, the Bank may have loan covenants that limit to a degree the freedom of movement of an owner. Loan Covenants can be Debt Coverage Ratio’s, Total Indebtedness, Minimum Cash on Hand, Limits on Future Indebtedness and other covenants. Traditional Lenders can also have restrictions against payments to owners, changes in ownership, selling off business assets, lease restrictions and other restrictions. Breaching loan covenants can put a business under increased scrutiny by the lender and can result in additional interest charges, can require additional capital investment by the owners or can ultimately lead to a loan being called or not renewed at the end of the loan term.
The lender's interest in the company comes in the form of receiving timely payments (principal and interest) until the entire debt has been paid in full. The business owner must understand that taking on debt increases the responsibility of producing more than enough revenues to cover the operating and debt expenses.
Using a local bank or a lending institution catered to your industry is the first option many prospective business owners look toward when financing their purchase. Most of these lenders have dedicated departments to assist the client with their financing needs. Each lender also has different loan eligibility parameters that the applicant must comply with in order to qualify for the loan. The lender will require that the applicant submit documentation in the form of an application, bank records, tax filings, plus any additional documents as specified by their loan underwriting requirements.
Traditional Bank Financing is more often used when the Borrower has substantial other assets and businesses (Good Credit Risk) and is utilizing bank financing to increase their returns. Bank financing can also be used more easily with businesses that have very predictable returns. An example of predictable business would be storage facilities or rental apartments with good track records or businesses with long term contracts in place with their customers.
Small Business Administration (SBA) Loans
Within the traditional financing realm are SBA Loans, these are loans, through traditional lenders that meet strict government requirements and are guaranteed by the Small Business Administration. These are attractive loans with lower down payments and typically lower costs and interest rates. SBA Loans are discussed in detail under SBA Loans.
Cash Plus Seller Financing
Seller Financing is when the Seller of the Business will take back a portion of the Sales Price through a Promissory Note or other payment contract where the Buyer will pay a portion of the Sales Price over time. These agreements can extend over a period of years and may or may not have balloon payments and market interest rates.
In Seller Financing, the Seller is allowing the Equity of the Business to pay the Seller’s price over time. Seller financing is done through either secured or unsecured promissory notes. Seller financing is not preferred for the Seller financing can result in a higher overall price being paid at the closing, due to the Seller facilitating the deal. Seller financing is usually secured by the assets of the Business and a Buyer runs the risk of a Seller, who by their nature understands how to run the business, may be more likely to be stringent with the Buyer and take back the business if the payment terms are not being met.
Seller Financing is discussed in greater detail here
Cash Plus Equity Financing
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Equity financing is the process of accessing capital for the business through the issuance of ownership shares in the business. These investors, sometimes called angel investors or venture capitalists, depending upon the size of the capital injection, are not lenders. They are partial owners of the business, and will ultimately either make or lose money on their investment based on the success of the company.
The main advantage of getting equity financing is that there is no loan attached to the funding, meaning there is no monthly principal and interest payment due. This provides more liquidity to the business to finance its operation and/or growth. Additionally, the equity financing investor may have business insight and relationships that may aid in the growth of the company.
The main disadvantage is that you are giving up a portion of the ownership to another party. Making future decisions will likely involve their input and approval.
In using equity financing you are taking on partners. The more that is being done through equity financing the greater the percentage of the business you may be giving up. Often, Equity Financing will have covenants and requirements similar to banks in that major decisions must include the consent of these investors. Equity Financing will often be done with family and friends, Angel Investors, or with more traditional larger equity and venture capital groups. Often a successful business may get a large capital infusion which can fund purchases of additional or complementary businesses from a Venture Capital or Equity Group.
Buyers will almost always need to bring their own capital to the table, in order to obtain Equity Financing, except in the occasional case of a Family or Angel Investor facilitating a purchase.
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