Show Me The Money!
If you’re a business broker – or the buyer or seller of a business – you know that the only way a deal gets done is if the money is found to make it happen. While this topic is broad enough to fill a book (and if you think an eBook might be appropriate, let me know), a blog post is more suitable to an overview and that’s the approach I’m taking here. You can use the comment section at the bottom of the post to describe whatever specific financing issue you have and I’ll address it in an email.
There are only three categories of capital as it pertains to financing a business acquisition: cash, debt and equity. Cash, of course, is what the buyer can stroke a check for. Apple, for instance, with roughly $260 billion in cash, can buy pretty much anything it wants by writing the proverbial check. In May of 2017, Apple bought Lattice Data, an artificial intelligence company, for $200 million, pocket change relative to its available cash. However, cash as the vehicle to affect a business acquisition is a relative rarity in the Main Street and Middle Market segments except at the low end of the former and the middle to upper end of the latter.
The Main Street market includes ultra-small businesses that might have a value of less than $50,000. It is not uncommon for such businesses to be sold for cash. Likewise, in the Middle Market segment, some businesses with transaction values in the $5 million to $15 million range that are acquired by private equity groups (PEGs) are acquired with cash. However, the vast majority of business acquisitions are accomplished with debt, equity or a combination of the two. Because so few deals are done with cash, this post will focus on debt and equity as the most likely vehicles that will be available to you.
In a debt transaction, the business buyer is borrowing the money and must repay that money. In an equity transaction, the money the buyer uses is invested by a third party. As a rule, this money does not have to be repaid. However, this money is not free. The buyer pays for it in equity – giving up some amount of ownership in the acquired business to whoever invested that money.
Most of us are familiar with debt financing. If you’ve ever financed the purchase of a car, a boat or a house, you used debt financing. Debt is the most common method of financing the acquisition of a business and there are multiple types of debt financing. Let’s look at the most obvious.
- Conventional financing. Generally associated with bank financing, this is most commonly used when the buyer is strong financially and has a relationship with a banking institution. The buyer and seller agree to the acquisition price and terms, and the buyer heads for the bank to apply for the loan to complete the purchase. Depending on the business’ financial condition, historical performance, future outlook and other measures, this route is likely to require the buyer to put between 25% and 50% of the purchase price into deal. By way of example, acquiring a business for $2 million will generally mean that the buyer will have to put up at least $500,000 in cash to get a conventional lender to fund the remaining $1.5 million. Conventional financing is usually the least expensive form of financing an acquisition; that is, the interest rate charged to the borrower is generally lower with conventional financing than with any other form of debt financing – with the possible exception of SBA financing. (More on the SBA programs in a moment.)
- Non-conventional financing. There are dozens of different sources for non-conventional financing including hard-money lenders, local investment groups, local or regional government programs, etc.
- Hard money lenders are generally sources of short-term funds, usually no more than a year. They are also very expensive (high interest rates) and often lack flexibility; it’s their way (terms) or the highway (as it were). This is generally a source we would avoid.
- Local investment groups are often motivated by a desire to keep a local business in the hands of local owners. To find such potential lenders, check with local accountants, attorneys and bankers.
- SBA financing. The U.S. Small Business Administration administers several programs designed to help the buyers of small businesses get their deals done. The SBA generally does not directly lend money to borrowers but rather guarantees bank loans thereby making conventional lending institutions more willing to make such loans. In Episode 8 of our podcast series, I interview Dave Moore with Acclivity Financial, a preferred SBA lender, about SBA loans and the SBA process. It’s worth a listen.
- Family and friends. As this is where most startups start their search for funding, it would make sense that the buyers of existing businesses – an adventure that occasions significantly less risk than a start up – would consider this source of funding. Family and friends may bridge the gap between what the buyer has and what the lender is willing to finance. For example, of the lender will finance 70% of a $1 million acquisition and the buyer has $150,000, family and friends could provide the remaining $150,000 to close that gap. However, borrowing from family and friends entails its own set of unique challenges in that each person lending any money MUST be fully informed of the risk and you should be extremely careful to take such funding only if the lender would not be negatively impacted if the business cannot repay it. This method of financing has ended too many friendships and too many family relationships to be taken lightly. Use family and friends with great caution.
- Seller financing. Somewhere around 80% of all acquisitions of small and medium size businesses involve some degree of seller financing. Sometimes the seller is the only lender. Other times, the seller closes the gap between what the conventional lender will provide and what the buyer has to invest. Sometimes seller financing is set up as an “earn-out“, whereby the seller stays on with the business and the final purchase price is determined by the business’ performance over a relatively short (two to five year) period. A good business broker will advise his or her client early on that seller financing is usually (80%, remember?) part of a business acquisition. This eliminates the potential for surprise when such financing is required.
Equity financing entails giving up some amount of ownership; if you’re the buyer, you’ll now have partners. Equity financing is more complicated than debt financing insofar as everybody involved now has skin in the game and it is not uncommon that they will, not unrealistically, voice their interests and concerns to whoever is managing the acquired business; that’d be you, if you’re the buyer. Structuring the owners agreement is a critical component of this type of financing, not least so that everybody’s roles are defined and who has what powers, responsibilities and restrictions are clearly laid out. If equity financing is the path chosen for the deal you’re in, I recommend consulting with someone that has been down that road, preferably more than once.
The first time I used equity financing, I was fortunate enough to have two sophisticated businessmen as investors. Both were far more experienced than I in both business and finance. They did the necessary due diligence and satisfied themselves that there was a reasonable chance of success. Both knew the downside and both could absorb the loss if the venture failed – as it did, spectacularly. That outcome notwithstanding, I was able to maintain excellent relations with both investors.
Equity financing differs from debt financing is several ways but the most significant and most likely is that the person or entity receiving the money has no responsibility to repay that money. Equity investors are generally looking for a much higher return on their investment than lenders (debt financing). Several sources of funding – family and friends, private investment groups and angel investors, for example – can be lenders or equity investors.
Lenders will generally view the interest rate applied to their loan as their return. They’ll look for security (collateral) and, usually, the borrower’s guarantee. Equity investors are generally unsecured and require no guarantees. They understand the risk but expect significantly higher rates of returns for their investment than they would get as a lender. They are usually repaid in two methods.
- Distributions. A profitable business generally distributes its profits to the owners on some predetermined schedule, be it monthly, quarterly or annually. Equity investors are owners. If the buyer of the business recruited three investors and each owned 20% of the equity in return for their investment, they would each receive 20% of the money the business distributed at any given time. For example, of the owners – the equity investors and the principal business buyer/manager who put up the balance of the purchase money – decided that every quarter the business would distribute X% of its profits from the previous quarter, the three equity investors would each receive 20% of that distribution with the balance going to the principal business buyer/manager. This would continue for as long as the equity investors were owners of any portion of the business.
- Exit. Equity investors also gain some return on their investment when the business is sold or if they are bought out via a sale to another investor (third party or one of the other original investors) or the principal business buyer/manager who might eventually want to buy out ALL the investors. The ways to set up equity investments, distributions, buy-outs and other exit strategies are too numerous for this blog post but we’ll touch on them in future post, so remember to subscribe.
Equity financing can really be provided by pretty much anyone with capital to invest but there are some standard sources.
- Family and friends. The discussion of this category, above, holds true here as well.
- Local investment groups. Again, there are many groups of private investors that are interested in keeping local businesses in local hands as well as affording local up and coming business people the opportunity to get into business. Finding these people or groups is not necessarily difficult but it also is not very quick. If you’re a buyer, discuss this option with your accountant, your attorney and your banker. If you don’t have a relationship with any of those professionals, start one. Ask around. Ask people that you know that are in business for recommendations and even an introduction.
- Angel investors. Angel investors are similar to local investment groups except that angels will often invest by themselves (without a group) and many times will consider a wider geographic area to invest in. Granted, most angel investors want to be able to watch their investment occasionally but many will have a wide investment radius; sometimes up to 100 miles or more. Finding angel investors can involve asking the professionals in your network but an internet search would be significantly worthwhile.
- Private equity firms. PEGs are usually interested in larger valuation deals. I’ve found that $5 million to $25 million is the ideal range but there are smaller PEGs that look at smaller deals. We work with a large group of PEGs and may be able to help you find the right one for your acquisition. Let me know in the comments section below.
Planning the Financing
Giving the financing serious consideration prior to bringing a business to market is an important step in helping to make the transaction as smooth as possible. For instance, certain businesses will not qualify for an SBA-guaranteed loan. Other businesses – service businesses without long-term contracts, for example – will have few hard assets to pledge. These will likely be candidates for seller financing.
As a professional business broker or the seller of a business, you should consider early on where the financing to make the deal happen is likely to come from and lay the ground work with buyers as they come to the table and with the likely financing sources. This will help is structuring the buyer’s offer and the ultimate purchase agreement. It will also increase the odds of the transaction actually being completed which is everybody’s objective!
If you have any questions or comments, put them in the Comments box, below. I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast. And feel free to email directly at jo*@Wo*******************.com.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!