In the fifth chapter of How to Buy a Digital Business, we look at the options in regard to financing an acquisition. You'll gain insights on acquisition finance in cash, debt financing, leveraged financing, and private equity. If you want a more professional looking and complete e-book, you can download the PDF.
5. Acquisition Financing
How you choose to fund your business acquisition could set you up for success or be a drag on your bottom line. While nearly half of business purchases are made in cash, looking to leverage your purchase with another funding source or two might give you a better return on your investment. A few questions to keep in mind when reviewing your options:
- How much cash do I have available for a business purchase?
- How much debt am I comfortable taking on?
- How much free cash flow do I need the business to generate to cover my loan payments?
- Might the seller consider a seller note?
- Am I comfortable leveraging my home or retirement savings?
- Am I comfortable with an equity investor?
Depending on how you answered the questions above, some of the following options will appeal more to you than others.
Sometimes sellers will allow buyers to finance a portion of the company purchase through the profits of the business over time. This can help close a deal more quickly, especially if you are not a good candidate for a traditional loan. The amount a seller will allow you to finance is usually not more than 60% of the purchase price. The length of the contract is often 5-7 years and can feature a balloon payment at the end. Of course, if other buyers are offering all cash, you will likely be at a disadvantage.
Home Equity Loan
If you have more than 20% equity in your primary residence, this could be a source to consider. You will want to allow a cushion in case your home’s value declines, but generally your interest rate will be competitive, if not better, than what traditional lending sources such as banks can offer. HEIL and HELOC lenders will look at your credit score as well as your debt-to-income ratio as part of a decision.
Traditional Bank Loan
If you are considering more traditional financing, you should speak with a local bank, credit union, or online bank. Getting financing for an existing business is often easier than for a startup, but it can still be challenging. An existing business will need a good track record of strong cash flows and assets. You’ll also need a very good personal credit score and may need to put down up to 30% of the purchase price in cash. A line of credit for your business is also a possibility, if you don’t need to finance the whole purchase and just need help managing the cash flow. For example, you may be asked for a business valuation, a record of your business experience, and a business plan. Lenders will likely want to see the following:
- Personal credit score
- Business credit score (if you already own a business)
- Tax returns
- Cash flow statement
- Outstanding debts
Finances of acquired business
- Balance sheet
- Business tax returns
- Profit margin
TIP: An SBA backed loan makes a bank more likely to lend.
Some business sellers will advertise that their business is eligible for a Small Business Association (SBA) loan, meaning that the seller has pre-qualified the business for an acquisition loan. An SBA guarantee will get you a lower interest rate with a bank, because the government agency is shouldering some of the risk of the loan. If a business is not advertised as SBA qualified, you can still apply for one through an eligible lender. The SBA has high standards for qualifying a business and a purchaser, so while desirable, it is not easily obtained. Here is a summary of the main loan types:
- Standard 7(a): Up to $5 million, 5-10 business day turnaround, 75% guarantee for loans over $150,000, 85% guarantee under $150,000, up to 10-year line of revolving credit.
- Small Loan 7(a): Up to $350,000, 5-10 business day turnaround, 75% guarantee for loans over $150,000, 85% guarantee under $150,000.
- SBA Express: Up to $350,000, 36-hour turnaround, up to 50% guarantee, up to 7-year line of revolving credit.
401k Business Financing
This type of financing is known as ROBS, Rollover for Business Startups. Offered by Guidant Financial and others, it allows you to use your IRA or 401k assets to invest in a new business. Essentially, the retirement fund becomes an investor in your new enterprise by buying stock in a newly formed C Corp. You can then use that cash to help buy the business or manage your cash flow like a line of credit. You will need at least $50,000 in your retirement account to qualify. This type of financing is often used as a second or third tier when needed. The danger is that if the business fails, your retirement savings will be jeopardized.
To avoid the burden of debt and share the risk of an acquisition, some buyers will look to take on investment partners. An investment partner could be a family member or friend that wants to help you get into business, or it could be a partner, angel, institutional investor or crowdfunding partner seeking a return or fee related to their investment. Partners may want equity in the business, a share in the profits, or a simple monthly loan payment. Most small business investors opt for a debt payment, because there is less risk involved. If you have a fast-growing e-commerce business, then an investor may opt for an equity investment or convertible note that could convert to equity in lieu of repayment. This allows the investor to get an interest payment at a fixed rate for a fixed period and also enjoy the benefit of upside if the business does well. The Small Business Investment Companies SBIC has a venture capital program consisting of equity and debt that includes SBA dollars along with private funds. The basics are:
- Debt: $250,000 to $10 million loans; 9% to 16% interest
- Equity: $100,000 to $5 million investments
- Debt with equity: $250,000 to $10 million; 10% to 14% interest
Whichever path you choose, make sure you have a written agreement and that you are comfortable with the terms of the transaction. Having an attorney review it is always advisable. Also, depending on the situation you may be required to get an exemption under federal and state securities laws (e.g. Reg D) or register as a private offering with the SEC.
Lastly, you will need some cash on hand to run the business and to ensure that any loan payments are manageable. Weighing the pros and cons of each option before moving forward on an acquisition will put you in a stronger position for the future. Owning a business can provide a nice income and lifestyle, but you have the best chance of success when you secure the right funding mix for your deal.
Takeaways: Questions to Consider
- Do I plan to pay cash for the business or to finance it?
- What finance options give me the best terms?
- Do I want to use more than one finance source?
- Can the debt payments for the purchase be met by the cash flow of the business?
Images from Pixabay