Where To Find The Money To Buy A Business?
Obtaining capital to start up a new business enterprise, purchase an existing company, or grow an established business can be a daunting process for many entrepreneurs and business owners. The sub-prime lending crisis and sluggish U.S. economy over the last 18 – 24 months has caused many traditional lenders to modify their lending criteria, and therefore restrict available credit and the flow of capital to many entrepreneurs and business owners.
Despite these economic conditions there still remain numerous funding options for business acquisitions to raise capital for either a start-up business of an established company. Engaging a financial professional to assist in evaluating the myriad of available funding options and finding the solution that best suits the business will streamline the process.
For those seeking capital to acquire an existing business or expand the current company, a variety of financing options are available that you can find through a factoring company or credit union which will help the business establish a track record of positive cash flow and a healthy amount of collateralized assets (supported by three to five years of financials/tax returns).
Commercial Banks/Finance Companies
Banks and traditional lending agencies provide commercial loans, both asset and cash flow based, to entrepreneurs pursuing either a start-up venture or the acquisition of an existing business. There are a large number and variety of commercial lenders and each institution will have different policies and standards that will determine the availability of funding.
The loan term and interest rate (including whether it is fixed or variable) can vary considerably, so it will be important to speak with a variety of financial institutions. Unsecured loans can often be misleading as banks and other finance companies will always seek to obtain as much personal and business collateral as possible.
In addition, it will be necessary to have adequate cash to make a down payment (most commercial lenders will require at least 20%) and be prepared to sign a personal guarantee. Working with a financial institution where an existing and favored customer relationship is already in place will assist in the loan process.
The Small Business Administration (SBA), is a United States government agency that administers loan guaranty programs to promote development and growth of small businesses. The SBA is not a “lending” agency that makes the actual loan but is the guarantor for the loan.
An individual will arrange to borrow the funds through an authorized SBA lender who then establishes the terms and conditions for the loan based upon the current SBA guidelines. It is important to note that while all participating SBA lenders, both banks and non-banks, adhere to SBA eligibility guidelines, the terms and conditions of the funding offered can be dramatically different based upon the particular lender selected.
“It is not unheard of, for a borrower to be turned down for SBA financing by one institution but readily accepted by another. This is often a result of the financing criteria of the individual lenders and whether it is asset or cash flow based”, indicated Steve Mariani, President of Diamond Financial Services.
- General Program (GP): With GP designated lenders, SBA has complete responsibility for reviewing and analyzing the loan package as well as making the loan approval decision. This process typically adds 3 to 4 weeks to the overall approval time of the lender.
- Preferred Lender Program (PLP): Lenders that receive this premier SBA accreditation are very unique as the final credit decision has been delegated to them. They often have reduced paperwork requirements and will retain most of the loan servicing and liquidation authority. PLP lenders are nominated based upon a successful historical record in SBA underwriting. PLP is the highest SBA lending designation where the lenders provide the most expeditious process based upon the autonomy received to approve loans in-house without the requirement to submit for SBA review.
The Small Business Administration offers many different loan programs directed toward small businesses and entrepreneurs. Each program offers different types of financing, providing flexibility and options for the borrower. While a brief summary of each of the programs is detailed below it is recommended that the prospective borrower engage an expert on SBA loans to determine suitability. Here are some of the more common programs we see used in the market.
- 7(a) Loan Program: This is the most flexible and popular loan program offered through the SBA as it can be used for a variety of general business purposes for both start-ups and existing small businesses. 7(a) offers loans up to a maximum of $2mm with maturity terms up to 10 years for general business and typically up to 25 years for certain types of fixed assets (including real property).
- 504 Loan Program: The SBA 504 program is viewed as a long-term financing mechanism for economic development. It is designed to provide owners of existing small businesses with “brick and mortar” funding typically for real estate and equipment purchases for both modernization and expansion. These are most often longer term fixed-rate loans that cannot include any working capital, soft costs, or closing costs associated with the loan. Frequently, a Certified Development Company (CDC) will work with both the lenders and SBA to provide this form of financing. For a business to be eligible for this loan, it must be a “for profit” enterprise and have an average (after tax) net income not in excess of $2.5mm or tangible net worth not in excess of $7.5 million. Speculative investments in rental real estate is prohibited.
- Microloan: The SBA Microloan Program offers short term, small loans to businesses and to “not-for-profit” child-care centers. The maximum loan amount and term under this program is $35,000 and 6 years. These loans come with restrictions and are designed for use as either working capital or the purchase of supplies, furniture, inventory, machinery and equipment. Microloans are managed through nonprofit community based lenders (i.e. intermediaries) which, in turn, will make these loans to eligible borrowers.
SBA Loan eligibility requirements, rules, and fee’s change on a regular basis and they are not always easy to interpret. Additionally, not all SBA lenders are active and proficient in all market segments and geographies. The best way to pursue an SBA loan is to work with a financial services company that specializes in this area and has relationships with all of the national SBA lenders. These companies have an expertise in pre-qualifying the application, developing the loan package, and presenting it to the lender that meets the specific criteria relating to your application for the greatest chance of approval.
Qualified retirement accounts can be an attractive source to obtain funds to finance business start-ups and acquisitions. Utilizing the funds in an individual’s retirement account (IRAs, 401(k)s, 403(b)s, Keoghs, SEPs) to invest in entrepreneurial endeavors has become a popular funding vehicle over the last 24 months given the very tight credit market.
This process is not a loan, requires no approval from a bank or lender, has zero interest expense and is based on long standing provisions of the Internal Revenue Service. This funding vehicle is based upon repurposing pre-tax dollars from a qualified retirement plan to fund an acquisition or start-up without incurring early distribution taxes or penalties.
Here’s how it works: An entrepreneur creates a new corporation and a corporate 401k plan for that corporation. He or she then rolls over existing retirement funds from a former job and “invests” that money in corporate stock. The cash from the stock sale is used as business capital and can even be used to receive a salary during startup. Because the money is invested in stock, there are no early withdrawal penalties or taxes to pay. Using retirement funds can reduce or even eliminate the need for business loans.
“Individuals may use a portion of the funds as a down payment on an SBA loan or could use 100% of the retirement account to invest in a new start-up company or fund the acquisition of an established business”, commented Doug Smith, Director of Business Development at Benetrends, Inc.
Friends and Family
Asking friends and family for financial assistance is probably the longest-standing method of funding entrepreneurial endeavors. Friends and family can often be a good source to borrow money for a down payment or even to become a partner in the new company.
Some individuals may be hesitant for fear of straining relationships but when approached properly with an upfront detailed discussion to determine how much they are able to invest, the targeted business criteria and the terms for either repayment or business equity, this form of capital can be the quickest and most cost effective form of financing available. Upfront discussions should be held reviewing how much is available for investing, what is the targeted business criteria, and what would be the terms for either repayment of business equity.
Home Equity Loans
Home equity lines of credit are an excellent method to finance all or part of a business start-up or acquisition. Typically, home equity lines of credit will charge a lower interest rate than commercial loans and allow the home owner to borrow money in increments as it is required.
Since lenders will typically seek to secure a commercial loan with the home equity, it may be more efficient for the borrower to take out a home equity line of credit and take advantage of the better rates and terms. Entrepreneurs who plan on quitting an existing job to pursue business ownership should establish the home equity line of credit prior to leaving their current job. Also, there are several other special housing loans in some states like the California home improvement loans that can be explored.
It is rare for a privately-held business to change hands for an all-cash price. More common in ‘small’ business sales would be to have a component of seller financing as part of the deal structure. Seller financing is a mechanism where the business owner takes part of the purchase price in cash and the remainder in the form of a promissory note that the buyer will pay back with interest over a period years. This type of deal can be very flexible — the seller can adjust the payment schedule, interest rate, loan period, or any other terms to reflect the seller’s needs, business cash flow, and the buyer’s financial situation.
It is advantageous to the buyer as they are required to come up with less money up front and can pay back the seller’s note out of the business cash flow. Many buyers will leverage bank financing to acquire a business and the majority of these lenders will require a component of seller financing to underwrite the loan. Seller financing, in the lender’s eyes, mitigates risk as they will have the additional confidence knowing that the seller has a vested interest in the future success of the business.
The seller, in this instance, will be providing secondary financing to the bank’s acquisition loan (i.e. subordinated debt) for the remainder of the price. Seller’s are often able to maximize the transaction value by earning interest on the promissory note and could realize tax benefits when they free e-file should the sale be compliant with the IRS installment method of reporting.
Larger business start-ups or acquisitions often involve a package of different layers of capital which could include bank debt, mezzanine financing and private equity. The type of business being acquired, the valuation of assets and cash flow, perceived market risk, as well as the growth plans, will be the characteristics that determine which capital sources and financing structure will be the most appropriate.
There are a variety of options and capital sources in the market providing both equity capital and debt financing including commercial banks, commercial finance companies, mezzanine investment firms, private equity groups and small business investment companies. Securing capital for a privately owned ‘middle market’ acquisition can be a daunting and challenging task, based upon the large number of institutional capital and financing sources that operate in the markets of today.
Each of these private capital sources will have a unique investment criteria and it is recommended to receive professional assistance to determine which financing is appropriate, competitively priced, and structured to meet the needs of the company. A competent capital broker can be of immeasurable assistance in formulating a solid business plan and strategy for funding the business. Experienced capital brokers typically have relationships with hundreds of lenders and investors and are positioned to provide a wider selection of options and assistance in matching sources to the specific parameters of the requirement.
Senior debt financing refers to any type of outstanding obligation that takes priority over unsecured or other junior secured debt. Senior debt will often be secured by assets pledged by an individual or business (i.e. collateral) where the lender has put in place a first lien entitling them to the first claim on those assets in the case of a bankruptcy or liquidation.
Senior debt financing is generally made available through banks, finance companies, and private capital investors where it is recognized as the least risky form of secured lending. The amount of senior debt that is provided will be dependent on the type, quality, and value of the assets securing the loan in addition to the historical track record and stability of the operating cash flow.
Debt financing can be an excellent method to obtain capital to fund an acquisition or fuel future business growth without surrendering control of the company’s management decisions or giving up equity in the business. The interest rate, which may be fixed or variable, the term of loan, and the requirements for financial covenants will largely be based upon the strength of the balance sheet and the consistency of the cash flow.
Mezzanine financing is a hybrid form of capital with features of both debt and equity that is typically used to finance the expansion of existing companies or for use in business acquisitions. Mezzanine financing is unsecured debt that is subordinated to traditional loans or senior debt and relies on cash flow from operations for repayment.
Mezzanine denotes the pecking order in a standard transaction. Mezzanine debt resides in the middle, junior to bank debt yet senior to equity – hence the use of the term mezzanine. Mezzanine debt has a much higher risk profile based upon the lack of collateral requirements and its subordinated status to both senior debt and secured junior debt. It is a blend of traditional debt and equity financing that incorporates equity based options, such as warrants, with lower-priority debt to provide flexible longer term capital.
This form of financing can be very expensive with lenders looking for 20 percent or greater returns. The debt is typically retired through either a recapitalization (new round of financing) or, in some cases, by the company going public. While mezzanine financing may require the business owner to relinquish some measure of control over their company, the involvement of a mezzanine lender can be extremely beneficial as most are very financially astute and can offer helpful and strategic business advice.
Private equity is a field of finance where large funds purchase stakes in companies and/or entire business units to restructure its capital, management, and organizational framework. Typically, money is invested in companies that are not publicly traded or are invested as part of buyout of a publicly traded company in order to make it private.
Private equity investors often seek to partner with companies that have an experienced management team where they will usually purchase a controlling interest. It is an attractive solution for business owners who are either interested in obtaining funds for expansion or diversifying their investments and creating liquidity by taking cash out of the company in exchange for equity in the business.
The company is recapitalized permitting the business owner to sell part of the enterprise while maintaining a continued ownership position. Private equity groups seek to grow the business, and will often provide assistance to the owner in removing personal guarantees, paying down bank debt and injecting capital into the business for growth.
Their primary interest is to receive a return on their capital and, in many cases, to sell the business in 3-7 years. This model is very attractive to many business owners as they are in a position to reap the benefits of the growth and eventual sale of the business.
Angel investors are individuals who provide capital for start-up businesses usually in exchange for ownership equity. Typically, angel funding is a bridge from the early self-funded stage of operation to the time that venture capital would be available. Angel investors often affiliate in the form of a fund or an accredited investor group where they are able to pull capital together and collaborate on investments.
Most angel investors are successful wealthy entrepreneurs, who are seeking to assist other entrepreneurs get a business off the ground in exchange for a higher return on capital than is typically available from traditional investments. “Angel investors differ from traditional venture capital firms in that they invest smaller sums of money per round. Typically, angel investors will target 100k to 500k per round with venture capital firms usually starting around 1mm.
Angel investors/groups like to make decisions quickly and strive to take a board seat for investor protection.” commented Jason Denenberg, Director with Angel Capital Group. Angels can be an attractive source of capital for an entrepreneur as the business is not burdened with expensive monthly debt payments during the critical start-up phase. The entrepreneur seeking capital from angel investors should be prepared to relinquish some control of the company in exchange for the equity investment.
Angel groups typically hold meetings for their entrepreneur investors where they establish the investment criteria for companies that will be targeted and raise required levels of funding. Most Angel groups are highly experienced, and possess significant resources to evaluate and perform due diligence on prospective portfolio companies.
Securing financial capital is one of the most critical issues for those entrepreneurs pursuing a business acquisition. As discussed in this article, despite the tight credit market and pull back in lending from the traditional sources, there remain a considerable number of different financing options available. Each of these options will vary considerably and carry a number of distinct advantages and disadvantages. Borrowers who are open to creative solutions, willing to take some risks and consult with experienced advisors will be successful in finding the optimal funding source for the given opportunity.
Michael Fekkes is a Certified Business Intermediary (CBI®) at ENLIGN Business Brokers