When a small business owner intends to sell their business, and when someone is considering purchasing a small business, there are some business financing basics that both sides should consider.
And for the purposes of this discussion, when I speak of small business, I’m talking about a business entity with no greater than $2,000,000 in annual sales.
When it comes to business financing, the most important aspect of any small business purchase is historical cash flow that is supported by third party financial statements and seller provided source documents if required.
The harder the cash flow is to figure out or verify, the harder its going to be to get both sides to agree on a sale price.
The second element of financing a small business purchase is the composition of the assets being purchased and offered as security to a third party lender.
When the sales price is allocated into tangible and intangible assets, third party lenders are going to be very interested in the amount of goodwill that is included in the deal.
Goodwill represents the value placed by the seller on the future revenues of the business which represents potential revenues not yet earned.
Its not uncommon for a third party source of business financing to only finance a portion of goodwill or none at all.
The expectation of the lender is that either the buyer will be paying cash for the goodwill or the seller will finance it over time.
The biggest risk to the lender when considering a business acquisition financing request is the change of control risk.
The transition period where ownership and control shifts from the buyer to the seller will always be key to longer term business success.
To help manage this risk, business lending sources will look to a financing structure where the risk of potential loss is shared fairly among the buyer, seller, and lender.
Many small business purchases are financed on this basis with each party contributing or being responsible for financing one third of the final purchase price.
Especially when there is a significant amount of goodwill involved, the lender may only be interested if the vendor is also providing financing.
This is also why its very uncommon to see a small business purchase being financed largely by just a third party lender.
When you have a buying or selling situation where all parties involved understand and are prepared to help guarding against short term business failure, then its more likely that third party business financing can be arranged to complete the transaction.
When a buyer or existing business acquires or buys another existing business, there are basically two ways to go about it. You can purchase the shares of the company if its incorporated or you can purchase the assets of the company.
In either case, you will have to decide who the actual purchaser or buyer will be. For example, will you set up a New Co to purchase the shares or the assets? Will the shares or assets be acquired by your existing company, or by yourself personally?
There can be several different options that can be considered for tax purposes, estate planning, liability protection, and so one.
Unfortunately, one of the structure considerations that often times doesn’t get worked into the decision making process is what is the best structure for acquiring debt or equity financing to provide some or all the necessary capital to complete the transaction.
Lenders and investors are going to have their own take on this subject to allow themselves to better protect their risk and optimize their security position. Which is why its not a good idea to jump too quickly into what the post acquisition business structure will be before gaining a solid understanding that the business financing you will require will be available for both the go forward business opportunity and the manner in which you plan to structure the deal.
Its not uncommon for a good solid acquisition to have trouble getting financing due to the manner in which the go forward ownership is structured on both a stand alone bases and in relationship to the existing business entities and/or personal holdings.
As an example, its a common practice on an asset purchase to complete the transaction through a New Co. But a new company will not have any established credit and without the backing of a sufficient corporate or personal guarantee or additional security pledge, the deal may not get approved and funded.
The working assumption that anything you can come up with respect to business structure and security for an acquisition can get financed for the terms and conditions you’re seeking is flawed.
The relevant lender and investor requirements at a given point in time for a certain type of acquisition scenario should also be factored in before any final papers are drawn up.
Ok, so perhaps a descent into madness is a bit harsh, but when I see some of the things vendors do to sabotage their own deals, it truly makes me cringe.
Here’s an example.
A buyer calls me up this week and he’s trying to get a business purchase finalized. The company to be purchased is service based with a high percentage of goodwill in the purchase price. Typical of these types of deals, the buyer is putting in money, a lender is prepared to put in money, and the vendor NEEDS to put in money.
All parties are in agreement with the deal, except for one thing. The lender does not want the seller to get paid out too quickly and drain the available cash out of the company and is asking for a delay in vendor principal and interest payments for 1 year.
This is hardly an unreasonable request as no lender (or buyer) wants to be left with a cash strapped company within a year of the loan being issued. Because there is so much goodwill in the deal, there is very little real tangible security, so if there are any cash flow hiccups, both the buyer and lender are going to be … in the soup.
But in this particular cash, the vendor is prepared to kill the deal over this, so the buyer is calling me up trying to locate another source of acquisition financing.
News flash to vendors of the world
This is a good deal.
In this case, the vendor would get 70% of the purchase price on closing, and start getting repaid on the remaining 30% in 12 months.
While this is also a typical deal structure for this type of deal, in many cases the vendor will not consent to any amount of vendor financing, especially anything that will place them in a security position behind the primary lender entering the picture.
Usually a vendor will have to go through two or three potential buyers before they realize that 1) likely no one is going to purchase their business for cash (everyone wants to leverage their investment) and 2) no lender wants to take the majority of risk, especially for a thinly secured deal.
Once reality starts to sink in several months later, after a number of false starts, the vendor starts becoming a partner to the deal and considers taking on some financing risk.
In the mean time, money has been wasted on accountants, lawyers, and other advisory costs, not to mention lost opportunity for potentially both buyers and the seller.
So my advise to the caller was to go talk to the vendor and work it out. Any new lender I could bring to the table would offer a similar deal. And if they were to realize the current offer was on the table, they wouldn’t consider the financing request at all based on the strength of the loan commitment already offered.
Next to start up financing, acquisition financing is the hardest to arrange. So when you’ve got this type of deal in hand, grab it hard and don’t let go.
Because the likelihood of a better deal being out there, right at the moment you need it, is slim. And if you take too long deciding, the lender may pull the deal off the table leaving you with nothing, leaving you to start the process all over again with the next buyer.
Most buyers who are looking to acquire a business will need or want to secure third party debt financing to maximize the leverage of the business assets and cash flow and minimize their down payment.
Put it another way, all cash purchases are fairly rare with respect to business acquisitions. Even if an individual or company could pay cash, they will likely want to cover off some of the purchase price with debt capital in order to reduce their weight cost of capital.
But business acquisitions can be very difficult to finance with third party debt, even if the required business loan amount is only a small portion of the total funds required.
There are several reasons for the high degree of difficulty securing business loans, far too many in fact to effectively cover off here. Instead, we’re going to focus on one of the key things that kill many business acquisition financing applications and that’s the historical financial statements provided by the vendor.
First, a lender will want to go back at least 3 years, but would prefer a longer view of historical performance. The longer term view of the business may not support the repayment analysis, especially if the near term results are stronger than those 3 or 4 years ago.
Second, especially with smaller businesses, the historical financial statements are done under a notice to reader accounting statement, providing very little if any third party verification of the results shown. For acquisition loan requests, especially those based highly on cash flow, lenders will not rely on notice to read statements.
Third, its not uncommon for the vendor to pull out all the stops the last year prior to sale to make the statements appear as good as possible which can also distort them compared to long term results, creating a lack of lender confidence in the financing opportunity.
Fourth, vendor’s may have several strategies to withdraw cash out of the business to save on both business and personal taxes. These strategies may not be easily identified in the historical results and while the vendor can disclose them so a lender can add them back, vendor’s tend to only focus on what was actually reported.
Fifth, if the business has some amount of cash sale component, its not uncommon for the vendor to not report all sales. The result is that the financial statements understate the real financial performance of the business.
While the buyer is the one trying to secure the financing, the ability to do so will correspond directly to how much the vendor has invested in the historical financial statements. And the ability for the vendor to secure the highest possible sale price is going to likely depend on debt financing which will once again be influenced by the historical financial statements and the accompanying support information.
The key take away is that spending money on a higher level of accounting opinion and bookkeeping that can be more easily verified by the buyer and third party lenders should be considered an asset that can generate a substantial return by allowing the buyer to not only secure debt for the purchase, but a higher level of debt so the down payment does not have to be as substantial and higher purchase prices can be considered.
If you are a buyer or seller trying to complete a purchase or sale of a small business, especially for a service based business, you hopefully will already be aware of how to approach the process of financing the transaction.
If its not a cash purchase, and additional financing is required, both seller and buyer need to be prepared to self finance the deal. Basically the combination of cash and vendor financing will be all that’s going to work in a lot of cases.
Third party lenders have very limited interest in these deals as the transitional risk to the ongoing business is statistically high and there is very little if any hard security of value available to a lender to secure their lending position.
The current recession has dried up most of the sub prime business debt that is typically based on the historical cash flows of the business. Even when these loans are available, the lenders expect both the vendor and the buyer to be making significant contributions to the financing package, so even in the best case scenario, a third party lender will only provide 30% to 50% of the purchase price.
Lenders will also require the vendor repayment to be done over a longer period of time than typically expected by the vendor in order not to drain the business of cash and equity in the short term which can impact the longer term business health.
And any debt financing that may be possible to arrange is going to require a lot of third party accounting support of the last three years business operations before a lender is going to be comfortable with the strength of the underlying business. If the vendor has not invested sufficiently in third party reporting, its unlikely that the buyer is going to be able to secure any affordable business financing for the acquisition.
The biggest challenges right now in the market is that buyers are searching for financing that either doesn’t exist or that can’t be secured with what the vendor is got available to support historical financial performance.
The key take away is that the buyer and vendor need to try and figure it out themselves, or work together to try and get a third party lender to provide some of the financing to get the transaction closed.
For a acquisition financing to be secured, the final capital structure needs to be a win for buyer, vendor, and third party lender.
If you ever start going down the road to business acquisition or buying a business, where third party debt or equity is required, then there are some things you should likely be aware of.
First, outside of a start up, the financing of a business purchase is arguably the most difficult type of business related financing there is. Why? Because there can be lots of moving parts to try to understand each of which can have either a positive or negative impact on the business. The goal of the buyer and third party financier is to accurately assess the current health of the business to make sure it has the ability to grow and prosper in the years ahead, versus being on a steep decline with little hope for the future.
Second, because each situation is somewhat unique, any financing secured will be customized in some manner to fit the situation. Customization always takes longer than something you just pull off the shelf which means you’re going to have to allow for probably more time than you anticipated to get business financing in place.
Third, while its possible to secure debt or equity financing with little or no money down, its not highly probable in most situations. Statistics will show that unless the buyer has a significant financial risk, there is a greater likelihood of business failure due to the fact that when the going gets tough someone with less to lose personally is also less likely to fight through the adversity to achieve a better result. With little to no down payment in the deal, the walk away costs are not very high, creating the opportunity for the buyer and now new business owner to fold the tent quickly if things are not going well with the business.
Fourth, when goodwill is involved, there is an expectation by lenders and investors that the vendor will cover all or part of the sale price pertaining to goodwill. Without this involvement by the vendor it will be much harder and perhaps impossible to secure third party financing of any sort.
Fifth, because capital may be required from a third party source, the vendor, and the buyer, it can be quite difficult to come up with a comprehensive financing plan that works for all parties. Lots of patience is typically required to work through everyone’s requirements and manage through the trade offs and compromises that will inevitably be required to complete the deal.
Also, many times things just won’t be a good match among parties, so you also need to access the goodness of fit quickly and if its not likely going to be present, then cut off negotiations and move on to the next potential deal. This is another form of patience whereby the buyer needs to never get hung up on any one deal, but focus on their buying criteria and the deal quality for all parties.
This may require looking at several deals over a period of time, working through them one at a time in order to get a good result.
The process of locating and securing financing for a business acquisition tends to be the second most difficult form of financing to acquire after start up capital.
The degree of difficulty associated with acquisition financing has much to do with the concern a debt lender or equity investor has with how a change in ownership will impact the future financial health of the business.
In order to get comfortable with the transaction, there can be a considerable amount of due diligence and analysis required by the source of capital. Understanding these requirements can go a long way to successfully financing a business purchase of shares or assets.
So the starting point for a buyer is to acquire some basic knowledge of the process and to potentially acquire a financing specialist to serve as a coach in order to better approach the whole business financing process.
Lack of basic knowledge tends to result in unnecessary adviser costs and deal fatigue which usually leads to deal failure.
So what type of basic education should be considered?
First, the buyers need to develop an understanding of how deals get financed and basic deal structure. One common misconception buyer’s tend to have is that presenting a signed letter of intent from both parties to a lender or investor will be sufficient for the capital provider to generate a commitment upon completion of their own due diligence.
From a lender or investor point of view, a letter of interest is a non binding agreement that does not fully describe the transaction and related conditions which will need to be fully understood before a commitment is forthcoming (which only makes sense it you think about it).
Second, the buyer needs to develop a sense of the type of support information that needs to be present to support third party financing. The more third party financing requested, the higher the quality of available information needs to be to support a positive decision. As an example, sellers commonly show their last year immediately prior to sale to be the most profitable on record to support a higher sale price. However, from the perspective of a financing source, the historical financial statements need to show some sort of structured pattern of revenue generation versus the manipulations that can take place in the year leading up to a planned sale.
Furthermore, the external financial statements should be prepared by an accounting firm with a strong reputation and the accounting statement likely will need to be “review engagement” or higher, depending on the level of financing requested.
Third, if the buyer wants a high level of leverage, he is likely going to need vendor support in terms of a vendor loan as well as the vendor’s willingness to adapt the final terms and conditions of purchase to suit the requirements of third party lenders and/or investors.
Because of the uniqueness of each potential deal, buyers should consider utilizing the services of a financing consultant that can help the buyer 1) quickly ascertain if the deal can be financed, and 2) assist the buyer with the project management required to get the financing in place and the deal clsoed.
I’ve been on a roll lately talking about business acquisition financing and many of the things that need to be considered to secure this hard to pin down form of financing.
Even if business financing is not required and the buyer can pay in cash, there is still no guarantee the deal will be finalized, although its going to be significantly easier to close without having to worry about securing capital.
So putting sources of funds aside, what is the key to closing the purchase and sale of the shares or assets of an existing business?
In all the deals I have been involved in or observed, I can easily come up with what I believe is the #1 key to success, and that is for the buyer and seller to jointly project manage the deal to its successful completion.
While that may seem a tad obvious to some, here is a better way to describe what I’m trying to say.
The Buyer And Seller Have To Become Blood Brothers.
There I said it. As corny as that may sound, its the best way I can describe not only how important their interaction is with each other, but also the degree of comfort and trust that needs to develop between them during the buy/sell process.
Once the Letter of Intent is signed, they need to get out the hunting knives, draw out a little blood on their palms, and bond the deal.
What this ritual symbolizes is the understanding that has now been forged between the two parties which can be summarized as follows:
Putting aside issues related to financing or unforeseen events and disclosures, deals fall apart because there are too many cooks brewing the stew.
Both sides will have advisers such as accountants, lawyers, financial advisers, business consultants, insurance agents, etc. The larger the team, the less likely the deal will close without the buyer and seller staying engaged in the process.
Both sides will likely have to deal with a certain number of outside parties dictated by the composition of the deal. This can include licensing agencies, bonding companies, appraisers, environmental consultants, suppliers, customers, employees, unions, and so on and so on. As the number goes up, probability of success goes down.
In essence, the buyer and seller need to project manage their deal to completion. Too often one or both sides do not appreciate what this can entail and the result is the deal can get away from them.
By definition, a project manager understands all the tasks required, how they inter relate, any interdependency among tasks or events, time lines, and so on. Unfortunately for many deals, buyer, seller or both do not get very involved after the initial negotiations have been completed and if anything tend to step back and let the advisers take over.
Aside from project management, both sides also need to remain the decision makers. Deals tend to have a certain amount of twists and turns as the details get pounded out. With every curve in the road, there may require an adjustment or compromise on one side or the other. Advisers can be very good at providing their opinions for issue resolution, but their advise may also end up killing the deal.
As decision makers, the buyer and seller need to receive all valid input regarding various issues and decide if any particular issue is something that can be worked through or an outright deal breaker.
A good example of this is during the drafting of purchase and sale agreements. Each side’s lawyer’s job is to protect their client and get them the best deal possible. When the lawyers from both sides are taking a win/lose approach, trying to out due the other side with clever clauses and demands, the deal tends to go back and forth until the eventual impasse is created.
Its at this point where the buyer and seller have to look at the areas of disagreement, consider all advise, and make their own decision as to how an issue or issues will be resolved.
I’ve seen sellers overly disconnected with the process through up their hands and say, “I’m not a lawyer, so if my lawyer says it has to be this way or that, I have to go along with what he says”, basically making the lawyer the decision maker.
A blood brother to the deal would seriously consider what their lawyer has to say, talk to the other side if appropriate as well as other advisers that could add value to the situation, and then make their own decision whether to proceed or not.
If buyer or seller agrees to proceed against an adviser’s advise, the adviser involved must then find a way to make the deal work (be a deal maker) in keeping with the wishes of the person paying their bill.
This is one of the more common points where deals blow up, but there can be many others. As the number of people involved goes up, so do the levels of inaccuracies and misunderstandings that occur not to mention the lengthening of time lines.
And remember, most if not all the advisers are getting paid whether the deal gets done or not, so it truly is in both the buyer’s and seller’s interests to stay on top of what’s going on.
Obviously no amount of involvement can guarantee success, but the odds are greatly increased when the coordination of the overall project details are being well managed, the misunderstandings are kept to a minimum, and the advisers are directed to find ways to make the deal work versus blowing it up.
Arguably one of the most difficult forms of financing to secure is business acquisition financing.
The degree of difficulty has a lot to do with the fact that many business acquisitions of small and medium sized businesses fail after the change of control takes place, making financiers more Leary of this type of business financing request.
But don’ t despair if you’re in the process of trying to locate and secure capital for an acquisition. Financing is available and there is a solution for making sure that you get your hands on the money you need.
Simply put, you need to make sure that you’re focused on the details of the deal.
A lender or investor considering advancing capital for a business acquisition want to see that all change of control issues are properly addressed, all risk areas are covered off, and that there is a solid plan of action going forward led by a well informed and competent individual(s).
Basically, they really are going to get into the details.
And so on, and so on, and so on.
Basically, the details. Could be just a few… likely more in the line of several pages.
And in many cases, potential financiers are asking you to provide your due diligence assessment of all the things you should be worried about anyway regarding the proposed purchase, which can actually be viewed as a good thing.
After all, no buyer wants to invest their hard earned money and time on a failed venture. While there is never a guarantee of success as anything can get screwed up or get blind sided by unexpected events, covering off the obvious issues right in front of you is a good starting point on the road map to success.
Unfortunately, many prospective buyers don’t sweat the details and at times want to dive right in where angels fear to trend. And that’s exactly why they don’t get any financing.
The details can be a real pain. It takes time to deal with. It costs money to work with qualified advisors.
But the risk of not sweating even the smaller stuff can be catastrophic in nature when you’re trying to take on a business that you have never operated and will have much to learn about in the early going of ownership
The process of buying or acquiring a business can be a grueling and dragged out process with many false starts occurring before a deal is actually consummated. So before you even get to an offer to purchase, or even a letter of intent, go through these five questions to determine quickly if any prospect should be ruled out before too much time and money is spent.
1. Who’s in control of the deal on the vendor’s side? Many times its hard to tell who’s really in charge on the vendor side of the deal. Between brokers, and lawyers, and accountants, and business managers, the process can get very convoluted.
While you would think that the atual owner of the business would control the deal, in many cases this is not the case due to their inexperience in the sales process. If you can’t quickly identify and get comfortable with the decision maker, stop the process and move on. Too many cooks will likely spoil the soup and just have you running in circles.
2. Is the Vendor Willing To Partially Finance The Deal? Especially in business sales were there is goodwill factored into the purchase price, most third party financing will not consider the goodwill portion. Also, vendor financing provides a quazi buyer indemnification fund, helping to assure that the vendor is completely transparent during due diligence and ownership transition. Having a vendor loan in place is going to further motivate the seller to make sure the buyer is going to be successful long after the transaction is completed.
3. Is the historical financial performance of the business supported by 5 years of at least review engagement financial statements? Without review engagement or audited statements, you have very little if any verified financial data to go by. There are ways around this, but its going to take more time and money to verify the accuracy of results.
4. Do your source(s) of capital support the deal being proposed? If you are using your own cash, then you can obviously do what ever you like with it. However, most business acquisition transactions involve third party financing, which can have restrictions on the type and structure of a deal. Too often, purchasers think that if they can get a deal worked out that the financing will be the easy part and too often a good deal falls apart at the very end because the financing process started too late in the game.
5. Are you buying a standalone going concern business, or someone’s self employed status? A business can be very successful, but also near 100% dependent on the owner. If the owner has not developed systems and management and structure that can live without him, then it may be time to find another opportunity.