Author: Jeff Jagodinsky Date: 06/12/2019

Buying a Small Business: Steps Involved in Getting the Right Financing

Part I: Preparing for a Successful Acquisition

Anyone who has started his or her own business from the ground up knows that it’s an immense amount of work...and risk. When acquiring an already established business, however, much of the foundational work has been done and there are fewer unknowns — and, in some ways, less risk. Since there’s a proven track record and established customer base, it’s typically easier to get financing to purchase an existing business than to start a new one, but there are still important steps that need to be taken as part of the process. Whether you’re a manufacturer, distributor or professional service provider looking to expand through acquisition, or an employee buying the business you work for, here are key steps in the process.

Step 1: Identify Your Target Acquisition

The first thing to consider when contemplating an acquisition is your level of experience with that industry, market or type of business. The bank will want to know that you fully understand the management responsibilities of your new venture and have experience in the day-to-day business operations, as these are critical factors in the company’s ability to succeed and service the acquisition loan. For example, if you’re an equipment manufacturer looking to acquire a tool and die shop, that may be a natural fit with your existing business, as you already have a good feel for product engineering, quality requirements and pricing, so you’re in a good position to hit the ground running.

Step 2: Assemble a Team of Advisors

Start by involving an attorney to take the lead in things like creating a letter of intent and business purchase agreement. If you don’t know an attorney with experience handling acquisitions, talk to your professional network, starting with your banker and accountant. They’ll give you some options.

Likewise, if your current accountant isn’t comfortable being part of your acquisition team, ask for recommendations from your attorney and banker for one with relevant experience. In both cases, you don’t want to be the client they learn with, you want to hire professionals who show up with the experience you need.

You’ll also want to involve a business valuation consultant. It’s this specialist’s job to determine what the business you’re after is really worth. He or she will likely consider several valuation methods to determine the best path forward and ultimately use one or a combination of methods including asset, market and income valuation.

You’ll also want to involve your banker in the conversation as early as possible, as he or she can help you assemble this team. Your banker should have relevant acquisition experience, with insights on the best way to both structure the transaction on the front end, and position you for success by building the best long-term financing post-acquisition.

Step 3: Conduct Due Diligence

Step three is to complete due diligence to make sure you’re actually getting what you’re paying for and have an accurate expectation of your most likely rate of return. You’ll need to develop a deep understanding of the company’s current cash flow and where growth is likely to come from — what you believe will happen in the first 3–5 years. If the business has a relatively small number of customers, studying customers’ business patterns and investigating the strength of relationships is definitely prudent.

With the help of an attorney, an accountant and a banker with experience in small business acquisition, you’ll be able to pinpoint real and potential problem areas and where you may run into issues that need to be addressed before or after the sale. The time spent critically assessing all aspects of the company you’re buying is well worth the effort; in fact, it’s what could mean the difference between your business's success or failure.

Step 4: Prepare Documentation for Your Bank

The fourth step is to assemble the documents needed by your banker as he or she works at creating financing options. Key documents at this point include:

  • A copy of the formal offer to purchase
  • P&L and balance sheet trends over time, 3-5 years of history
  • A listing of business assets with depreciation schedules
  • Customer list and histories; any formal agreements or terms
  • Historical and projected cash flow analysis
  • An appraisal on the real estate and/or equipment you’re purchasing
  • A copy of the business valuation that was conducted
  • Other relevant information to help the bank determine if you’re able to manage the debt required by the business

Your banker will also want to understand your motivations and the growth potential the acquisition represents, so any evidence, such as a formal business plan that supports your assumptions and projections, will be helpful in discussions about financing.

Part II - Loan Options for Financing a Small Business Acquisition

Providing your banker with all of the information from your due diligence analysis will help him or her work with you to determine which financing option, or combination of options, is best for your acquisition transaction and beyond. The most appropriate structure will depend on your current situation and the aspirations of the business, as well as the expected volatility or risk anticipated. There are four primary options available for small business owners looking to acquire another business. These can be utilized individually in combination with one another:

Seller financing

Sellers often play a role in financing the sale of their business; a survey of business brokers by online business marketplace BizBuySell reported that 60-90% of businesses for sale included seller financing as part of the package. There are a few reasons this occurs as often as it does. It may be that small business buyers don’t have enough available capital to make a deal work without seller financing. What could also be happening is sellers sometimes prefer to finance all or a portion of the sale in order to reduce or delay his/her immediate tax liability. Seller financing can also be done in conjunction with a Small Business Administration (SBA) loan or with conventional financing.

SBA loans

There are two primary government-backed SBA programs available today, and both can be good options for financing an acquisition, if the borrower has at least a 10% down payment (rather than the 20-25% typically required with conventional financing).

SBA 504 loan program. This type of loan can only be used for commercial real estate, land, construction, building improvements, and equipment, so it could be used in an acquisition scenario to finance such assets. With this type of loan, the bank finances up to 50% of the project on a conventional loan in a first lien position. The SBA 504 loan is for 40% of the financing in second position – this is the portion of the loan that the rate and terms are locked in for the full term (up to 20 years).

SBA 7(a) loan program. For many acquisitions, an SBA 7(a) loan is a better fit than a 504 loan because it has broader uses and a more flexible structure. Proceeds can be used to expand, acquire or start a business, including real estate, equipment, working capital and inventory purchases. The benefit of this program is that the interest rate is fixed for the full term of the loan on the full amount. These types of loans do have an upfront fee because the SBA charges 3% of the guaranteed portion.

Municipal funds

Municipal financing can potentially be used for a portion of the business acquisition cost for buyers who can demonstrate that jobs would be lost if they didn’t buy the business (or that they will create jobs by expanding). The amount available is typically based on the number of jobs the purchaser is expected to save and/or create in the community. Typically, a municipality will lend around $20,000 per job, up to a total cap set by the municipality.

Conventional bank loan

Banks will consider conventional loans when the buyer is bringing a significant down payment and the important debt ratios are attractive. Conventional loans are often recommended when a buyer is able to put at least 25% cash down, the company’s asset-to-debt ratio is at least 4:1, and the debt service ratio is 1.2 or higher. The rates on conventional loans are typically fixed for three, five or seven years, so if you’re financing a 20-year deal, rates will be variable and/or you’ll need to refinance more often.

Compared to starting a new business, acquiring an existing business comes with its own unique challenges and considerations, but with proper planning, you can reap many potential rewards as well. Following these recommendations can help the process go more smoothly and alleviate missteps along the way.

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Topics: Business Acquisition

 

Written by Jeff Jagodinsky

Jeff has been a part of the banking industry for over 30 years, primarily working in commercial and conventional lending. He has deep experience with government-sponsored lending programs, including SBA, USDA and FSA. The part of his job he enjoys most is helping clients start and build their businesses to be able to reach their goals.

 

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