Often, the purchaser of a business will give the seller a Letter of Intent to purchase the business that is contingent on being able to secure financing. If you get to this step and you are not able to bootstrap the business financing all by yourself, there are a number of options available to you. For most buyers of existing businesses, the goal of financing is not only to acquire the business, but to make sure you have the flexibility and resources to grow.
What is a business acquisition?
A business acquisition involves one person or entity purchasing a business from another person or entity. This could mean a single person buying a local restaurant franchise from somebody else, or a large manufacturing company taking over the operations and production facilities of a smaller competitor. Whether your deal is large or small, simple or complex, chances are it will require some type of outside financing.
How can I finance a business acquisition?
When considering how to buy a business, the simplest way is to fund it out of your own savings or to access personal borrowing facilities such as a home equity line of credit. But for many business owners, these sources will not be enough. You may need to consider raising equity from investors or taking on some type of business loan. These are the same basic options used by large enterprises when they make an acquisition.
Many business acquisitions are financed by a combination of personal money, equity, and debt. Finding the optimal financing structure is important so you can have a smooth ownership transition and position your new company for growth while maintaining healthy personal finances in the process.
Equity represents ownership in a business. Often, the owner and operator of a small business is also its first equity investor using his or her own savings. Another source of equity investment could be friends, family, or a professional private equity or venture capital firm. Generally, the more equity that is invested in acquiring a business, the less debt that will be required. For example, if you were able to raise $400,000 in equity to acquire a $1 million business, you would then need to borrow $600,000 to complete the transaction.
Lenders like to see that the business owner and operator has an equity stake in the business. That means they’ll have put their own capital at risk and have something of their own to lose. This usually signals to the lender that they have a stronger commitment that might contribute to a more successful business acquisition.
Senior debt refers to the loan provided by the main lender. This loan is usually secured against the assets of the business, such as real estate, inventory, or equipment. The loan is called ‘senior’ because, in the event of the failure of the business, the senior lender has first call on those assets in order to recover their investment.
The amount of money a senior lender will loan is often tied directly to the expected earnings of the business. This is typically expressed as a multiple of the company’s earnings before interest, taxes, depreciation and amortization, or EBITDA.
For example, a lender might be willing to extend a loan equal to three times annual EBITDA. In the example above, where the business operator has $400,000 of equity and wishes to purchase a business for $1,000,000, the business would need annual EBITDA of $200,000 in order to qualify for a loan of $600,000.
Most senior lenders will make loans with relatively strict terms, requiring monthly payments and other covenants, such as meeting certain ongoing financial performance criteria.
It’s actually quite common for the seller of a business to provide some of the financing for its acquisition using what’s called a vendor take-back or vendor note. These deals allow the person acquiring the business to pay the seller over a period of time with interest.
For example, in the situation above, if the buyer of a $1 million business had $400,000 of equity and the business had enough earnings to qualify for a $400,000 loan from a senior lender, the buyer could bridge the final $200,000 of the purchase price using a vendor take-back.
There are several potential advantages to this approach. Not the least of which is potentially a lower interest rate, more flexibility on the payback schedule, and a seller with a vested interest in a successful transition and the continued success of the business.
Sometimes, even when a buyer lines up their equity, a senior lender and a vendor-take back, there is still a funding gap when attempting to acquire a business. This is where mezzanine financing comes in. Because it’s riskier debt for the lender, it generally comes with a higher interest rate. But, in exchange for that, it usually has very flexible repayment terms and can be a valuable part of your overall business financing package.
How do I find the value of the business acquisition target?
Valuing a business can be more art than science, but there are a handful of factors that you should consider — ones that any equity or debt investor is likely to as well:
- Assets. One of the most concrete elements of a business’s value is the assets that it owns. If the business owns things like real estate, equipment, inventory, or intellectual property, the value of these assets (minus any debts) can help establish its net asset value.
- Earnings. How much the business earns is also very important in establishing its value. Earnings mean how much the business keeps after paying all of its expenses (including the owner’s salary) and other costs. The actual value of the business may be based on multiplying its annual earnings. Generally speaking, the faster the earnings are growing, the more times you might multiply those earnings to arrive at a valuation.
- Comparables. One of the ways to contextualize valuations is to look at similar business deals. For example, you might see that businesses in mature and slow-growing industries are changing hands at just a few times their earnings, while fast-growing tech startups change hands at double-digit multiples. You might also see that some industries have lower-risk and long-established players, while others see new upstarts frequently come and go. You’ll want to factor those risks into your assessment.
How do I find funding for the business acquisition?
There are at least three general sources of business acquisition funding that you can explore:
- Personal sources, such as your own savings and friends or family who may wish to invest.
- Equity investors, such as private equity or venture capital firms and angel investor groups.
- Debt investors ranging from private firms who specialize in business acquisition finance, to the major Canadian banks and credit unions.
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