Sources of Financing

Date: OCT 22nd, 2008

Topic: Industry Experts

The source of financing depends in part on the size of the business being purchased. The majority of smaller and medium sized businesses are purchased with a significant portion of the purchase price financed by the owner. The chances of obtaining outside financing improve as the size of the business being acquired increases by virtue of the fact that the number of potential lenders increases. Banks, insurance companies, commercial finance companies and venture capital companies may be interested in lending money for a relatively large acquisition.

Personal Equity

The primary source of equity financing is usually the owners of the company. Typically, anywhere from 20 to 50 percent of cash needed to purchase a business comes from the buyer and his or her family. This usually comes from personal savings, the sale of real estate, loans against assets such as real estate, or liquidating other assets or investments.

Family and Friends

A common source of equity financing is what is referred to as OPM (Other Peoples Money). In many cases, this means family and friends. These people usually believe in you and don’t require the same kind of collateral as banks do. Careful consideration should be given before involving family and friends in the financing of your business. Consider how you would feel obligated to them and their financial; capability to provide funds before you approach them to invest.

If you do decide to approach family and friends, deal with the situation in a businesslike manner and present them with a formal proposal just as you would with any other potential investor. If they agree to invest, structure a formal agreement with agreed terms of repayment and interest. In other words, treat their investment as a business arrangement and not as a gift. If they decline your proposal, don’t take it personally.

Partnership

You may consider bringing a partner into the business to provide some of the financing, share the work and some of the risk. If you choose the partnership route, understand that the casualty rate of partnerships is very high. As in any form of business relationship it is critical to enter into an agreement, which sets out the responsibilities and obligations of each party before you commence business.

Seller Financing

As noted above, the majority of smaller and medium sized businesses are purchased with a significant portion of the purchase price financed by the owner. The owner may be motivated to provide vendor financing if he feels it is necessary to get the price he wants for the business, has confidence in the buyer, or is influenced by his own tax situation.

Typically, a seller will require the buyer to make a down payment and execute a promissory note for the balance. The down payment can vary from 10% to 40% of the selling price. The assets of the business usually secure the note, however, the seller could require the buyer to put up a personal residence as additional collateral and/or personally guarantee the loan. The interest rate charged on the note normally varies with the prime rate and is usually less than the interest rate charged by banks for business loans.

In some situations, the seller may require the buyer to take out a life insurance policy with the seller as beneficiary, so that the loan will be paid off if in the event that the buyer meets an untimely demise. In addition, the purchase and sale agreement may restrict the new owner's sale of assets, acquisitions, and expansions until the note is paid off, and provide for the seller to be provided with regular financial statements so they can keep track of the financial health of the business.

In most cases, financing provided by the seller will be for a relatively short term although the loan will be amortized over a much longer payment schedule to keep the payments to a manageable amount. At the end of the term (e.g., five years), there will still be a substantial portion of principal remaining and the seller will require the buyer will to obtain outside financing to pay off the balance of the loan. The basic philosophy is that at that point, the business will have a solid track record and it will be easier for the buyer to obtain bank financing.

Earn-Outs

An "earn-out" is essentially an agreement in which a minimum purchase price is agreed upon, with a provision that the seller will be entitled to more money if the business reaches certain financial goals in the future. Such goals should be stated in terms of percentages of gross sales or revenues, rather than net revenues, because expenses are relatively easy to manipulate, which can result in a distortion of net revenues.

An earn-out can be calculated as a percentage of sales, gross profit, net profit or other figure. It is not uncommon to establish a floor or ceiling for the earn-out.
Earn-outs do not preclude the payment of a portion of the purchase price in cash or installment notes. Rather, they are normally paid in addition to other forms of payment. Because the payment of money to the seller under the provisions of the earn-out is predicated on the performance of the business, it is important that the seller continue to operate the business through the period of the earn-out.

An earn-out is often used in situations where there is disagreement between the parties about how much the business is actually worth. An earn-out can also be a good solution if the buyer is uncertain about the future of the business since the performance payments can often be financed internally.

Lending Institutions

The most common sources for business loans are financial institutions such as banks although banks turn down far more loan applications than they approve. Before approving a loan request, a bank must be convinced that the loan's risk of failure is minimal and represents a profitable transaction. Institutional lenders are generally conservative and concentrate primarily on repayment. You will have a far greater chance of obtaining bank financing if you have a large net worth, liquid assets, or a reliable source of income. In addition, a borrower must be of good character, have a clear source of repayment and have a good business plan.

Collateral

It is unusual for a loan to be secured only by the assets of the business. An institutional lender is almost certain to require personal collateral for a loan. Collateral is essentially property that secures a loan or other debt, so that the lender may seize the property if the borrower fails to make proper payments on the loan. The most attractive types of personal collateral from the lender's point of view are real estate, marketable securities and cash value of life insurance. In start-up business, the most commonly used source of collateral is the equity value in real estate. The borrower may simply take out a new, or second, mortgage on his or her residence. In some states, the lender can protect a security interest in real estate by retaining title to the property until the mortgage is fully paid.

When lenders demand collateral for a secured loan, they are seeking to minimize the risks of extending credit. In order to ensure that the particular collateral provides appropriate security, the lender will want to match the type of collateral with the loan being made. For example, the useful life of the collateral will typically have to exceed, or at least meet, the term of the loan; otherwise the lender's secured interest would be jeopardized.

Consequently, short-term assets such as receivables and inventory will not be acceptable as security for a long-term loan, but they are appropriate for short-term financing such as a line of credit.

If a bank is willing to provide financing, it will typically finance 50 to 75 percent of the value of real estate, 75 to 90 percent of new equipment value, or 50 percent of inventory. The only intangible assets attractive to banks are accounts receivable, which they will finance from 80 to 90 percent provided they are current i.e., no older than 30 days.

Although the terms may sound attractive, most business buyers are unwise to look toward conventional lending institutions to finance their acquisition.

The Small Business Loans Act

Business Improvement Loans (BIL) are administered by the Small Business Loans Act (SBLA) that are guaranteed by the federal government. BIL's are designed to help small businesses obtain intermediate term loans from chartered banks and other designated lenders to help finance specific fixed asset needs. BIL's are made directly by approved lenders to small businesses with a loss-sharing agreement signed between the lender and the federal government. In the event you go out of business; the federal government will reimburse the lender for the debt outstanding up to a certain level (currently 90 percent).

The maximum value of loan cannot exceed $250,000. Loan proceeds may be used to finance up to 90 percent of the cost of the asset, including non-refundable taxes and duties. Lenders are obligated to take security in the assets financed. Under this program, the lender cannot ask for a personal guarantee from you that will exceed 25 percent of the original amount of the loan.

Loan proceeds may be used to finance:

  • The purchase or improvement of real property
  • The renovation, improvement, modernization of premises
  • The purchase and installation of new or used equipment

The period during which a loan must be repaid will generally coincide with the expected economic life of the asset being financed, up to a maximum of 10 years. Installment payments on the loan principal must be scheduled at least annually, but monthly payments are usually called for depending upon arrangements between the borrower and the lender. Borrowers may choose between:

  • Floating rate loans, where the interest rate fluctuates with changes in the lender's prime lending rate over the term of the loan, but cannot be more than 3 percent over the lender's prime lending rate; and
  • Fixed rate loans, where the interest rate is fixed for the term of the loan, but cannot be more than 3 percent over the lender's residential mortgage rate for the applicable term. This 3 percent includes an annual administration fee of 1.25 percent payable by the lender to the government.

A loan can be prepaid or the interest rate can be converted to a fixed or floating rate. The lender may charge a penalty for the prepayment or conversion of the loan.

Lenders are also required to pay a one-time loan registration fee to the government equal to 2 percent of the amount loaned. The fee is recoverable from borrowers who may reimburse the lenders when their loans are advanced or have the amount of the fee added to their loan balances, provided that the individual borrower's loan maximum of $250 000 in total is not exceeded.

Norman P. Friend
President
Franchise 101 Incorporated.