Business Acquisition Financing. Or Where Do I Find the Money to Buy a Business?

There are five places to find money for the purchase of a business. We’ll discuss each below.

FAMILY

Many times the older generation in a family will loan the down payment or the entire amount needed to a promising member of the family’s younger generation. If your family is willing to loan you the money, one word of advice is in order. Have a very clear understanding as to how the debt is to be handled and put it in writing in the form of a legal note. And even though it is family, I also suggest that the note carry a reasonable rate of interest. The written note with a reasonable rate of interest will not attract the attention of the IRS who otherwise might try to reclassify the loan as a taxable gift or income. Also, note that earns interest can keep peace in the family, particularly among other family members who might be a tad jealous.

BANKS

Although most people seeking a loan to buy a business will think first of banks, I can tell you from years of business brokerage experience that banks generally do not make business acquisition loans.

That statement will surprise most people. Once you’re in business, banks will compete for your patronage, but most will not stick their necks out in the beginning to make you a business acquisition loan. Bank advertising would lead you to believe they would do so, but in more than 90% of the cases, they will find some reason to decline the business acquisition loan application.

The exception might be if you have a strong, years-long relationship with a bank and you can offer some other collateral such as Certificates of Deposits. Or if the bank participates in the SBA loan program, they might be able to approve a SBA guaranteed loan (see SBA below).

So if a bank turns you down, don’t take it personally. And don’t take it as a reflection on the business. It’s just the way things are.

Now this is the humorous part of the situation. It’s ironic but it has happened more than just a few times. After you’ve been in business for a number of months or a year or so, the same bank that turned you down for a loan to buy the business may come calling on you soliciting your banking business! One of my clients in this situation said to the banker in all seriousness, “Well now Mr. Banker, we’ll be happy to consider your application for our business. Let’s see, we’ll need your financial statement and a list of references and your business plan for five years into the future. Once we have your completed application, I’ll be glad to take it before my committee and let you know of our decision.”

The banker was taken aback. I thought it was funny.


SBA

The SBA, through its approved lenders, provides business acquisition loans. The SBA generally does not make direct loans, but rather guarantees the loan that is made by the approved lender. It’s known as the SBA 7(a) program.

The SBA list of approved lenders includes some banks and many non-bank lenders such as CIT, GE Small Business Lending, and AT&T Finance. Some of these lenders will include an amount for working capital in addition to the price of the business in the loan amount. Down payment requirements range from 15% to 25% plus there are usually up-front fees involved for various requirements. Interest rates are competitive with the marketplace.

The SBA guaranteed loan requires a lot of detail and documentation. If you go this route, be patient. And stay on top of the SBA requests for information. The quicker you can get the information and documentation to the SBA underwriter, the quicker your loan will close.

The SBA route for a business acquisition loan is sometimes frustrating because of the time and detail that is involved. However, keep in mind that the SBA will approve loans that others have turned down and will usually approve them with a smaller down payment. In most cases, it’s worth the wait.


THE SELLER

In the majority of the business transfers that I handle, the owner of the business finances a portion of the purchase price for the buyer. Some sellers cannot offer owner financing for a variety of reasons, but when they can, it conveniently solves the problem of financing.

The fact that the business owner is willing to finance the sale of his company provides more than a convenient finance plan. More importantly, it provides a strong validation of the owner’s belief that the business will support the owner and earn enough cash to pay back the loan. You can’t get any better recommendation on the business than this.

Owner financing also keeps the owner “in the boat” for the duration of the loan. If the new owner experiences any problems, the seller has a vested interest in assisting.

The normal down payment for owner financing ranges generally from around 25% to 50% of the purchase price of the business. Interest rates are generally market driven but there is more flexibility here than in other forms of financing.

Of course, the owner is going to want to know a little about you before making a commitment to finance. If you’re going to ask him to finance the business for you, be prepared when you meet him to give him some background information on yourself and your business or work experience. Remember, you need to sell him on your qualifications as much as you need to be sold on his business. In future meetings with him, assuming you are seriously interested in buying the business, it would be an act of good faith on your part to give him your personal financial statement, a list of references and a copy of your credit bureau report (if it’s good). That shows professionalism.

Most owner financing – though not all -- is in the form of a balloon note. The balloon note solves two opposing desires. The buyer of the business wants to keep his payments low; however, the seller usually wants his money as soon as possible. By amortizing the note (calculating the payments) on, say, a 12-year payback schedule, the payments are kept low. But the inclusion of a 5-year balloon requires that the balance be paid off at the end of five years. After the new owner has been in business for five years and has built a track record for himself at this bank, he should have no trouble going to the bank and refinancing the balloon. In the low interest rate environment of recent years, I’ve seen new owners refinancing the balloon even before it came due to save money. The balloon note has been a win-win vehicle for both buyers and sellers.

401(K) FUNDS AND IRA ACCOUNTS

The use of these funds to buy a business, without tax penalty, is a recent development. Several national CPA and attorney firms have developed a plan, approved by the IRS, which allows you to use your funds for business acquisition.

There are legal and accounting fees involved, but they are a small fraction of the tax penalty that would be assessed for cashing in these accounts. For additional information on this option, call your CPA, attorney or business broker.

In my business brokerage practice, we have developed a relationship with a couple of firms that specialize in this area and we can make a referral for you.


A Trifecta

The above five sources of financing are not mutually exclusive. I recently handled a transaction in which three of the five sources were used to buy the business.

It’s called creativity!

Business Valuation / Appraisal. Or What is a Business REALLY Worth?

As president of the American Business Brokers Association and as a full time business broker, I’m often asked how one can determine the real market value of a particular business.

Nothing causes company owners or the buyers and sellers of privately held businesses more anxiety than the problem of business valuation. In a transfer of business ownership, the question of selling price haunts both parties to the transaction. The seller doesn't want to price his business too cheap and “leave money on the table”. On the other hand, the buyer of the business is afraid he’ll pay too much and not get the best possible deal.

The appraisal of privately held businesses is not an exact science but there are guidelines and rules-of-thumb that can be used for a close approximation of value. And formal business appraisals are now readily available. Professional appraisal firms can produce a quality report on the business with the conclusions of value thoroughly supported and documented, all done for a fee of around $1,500.

Certain situations require a formal business appraisal including the larger merger-acquisition transactions, SBA loan applications, management performance tracking, estate planning, divorce -- or the most dreaded of all -- IRS issues. After all, a professional, fully documented appraisal certainly takes the guesswork out of the situation.

However, what we will discuss here is not a formal appraisal but rather the informal methods of quickly approximating the value of a business entity. All of the guidelines we’ll quote are averages derived from thousands of completed transactions reported to national and regional databases.


Let’s First Define What We’re Appraising

Most small business transfers are asset sales and the appraisal guidelines that follow assume an asset sale. This means that the buyer of the business buys certain assets of the business – usually the furniture, fixtures, equipment, inventory, the business name, and goodwill. These assets are transferred to the buyer at closing free and clear of any encumbrances. Generally not included in an asset sale are the cash on hand and the accounts receivable. These two assets are usually are retained by the seller of the business.

The opposite of an asset sale is a corporate stock sale. In this case the purchaser buys the outstanding shares of stock in the corporation, thereby taking control of all the assets and debts of the business.

And a basic word on business value might be in order here. An on-going business entity that is earning a profit is worth more than the sum of its tangible assets. What is really being transferred in the sale of a business is an income stream. Business appraisers seek to put a value on that income stream.


The Two Appraisal Guidelines

There are two formulas for business appraisal guidelines. The first one -- and the easiest to use -- says that a business should be worth a certain percentage of its annual revenue. The other formula -- and generally the more accurate of the two -- uses a multiple of the cash flow that the business produces. These guidelines assume all furniture, fixtures and equipment needed to do business. The cost of current inventory on hand should be added to the formula results to obtain the business value. And as stated above, the sellers of most small-to-medium size businesses do not include in the sale any cash or accounts receivable. Hence, the guidelines do not include these items.

Nor do the guidelines include any allowance for real estate. The guidelines assume that the business is in a leased location at a competitive lease rate. If real estate, cash or accounts receivable are to be included in the sale of a business, their value should be added to the guideline results.

And these guidelines assume that the business is making a net profit percentage that is within the average range for the type of business. If the business is above or below average in profit percentage for its category, the resulting values would need to be adjusted accordingly.


Value as a Percentage of Annual Revenue

First, almost all privately held businesses with annual sales under $5 million are worth somewhere in the range of 20% to 80% of the company’s annual revenue. In one large database, the average price in the year 2000 of 3,8000 transactions was 44% of revenue.

Exactly where in this range of 20% to 80% of revenue the value of a specific business falls depends on the kind of business. The range in valuation percentages is reflective of the many differences in the various categories of businesses. For example, some types of businesses require more expensive equipment that others. And some categories of businesses historically take a higher percentage of total revenue to the bottom line as net profits. This is why convenience stores, for example, are at the low end and dry cleaners are at the high end of the range when business value is expressed as a percentage of total annual revenue.

If you’re looking for an auto parts retail store, as another example, you should expect to pay about 45% of revenue to purchase the business. Let’s say you are looking at a tire store with auto service. You should be able to buy it for somewhere around 40% of sales. Other examples: dress shops sell at around 20% of sales, coin laundries at 75%, franchised fast food outlets at 50%, print shops at 50%, vending routes at 65%, video stores at 55% and restaurants at somewhere between 25 to 35% of sales depending on type. Manufacturing operations sell for somewhere in the neighborhood of 65% of revenue depending on the product and other factors.


Value as a Multiple of Cash Flow

The other set of guidelines seeks to approximate the value of a business by applying a multiple to the annual cash flow that a business generates. This second guideline states that most companies will sell for between one to six times the discretionary cash flow produced by the business. Exactly where in this range that a specific business falls, again, depends on the type of business.

From the database of completed transactions, we know that an air conditioning/heating contractor would sell for somewhere around 1.5 times cash flow. Beauty salons go for about 1 times cash flow. Day care centers that are licensed for 100+ students sell for around 4 times. A hardware store is worth approximately 1.2 times. Other examples: Home health care is 3 to 5 times, janitorial services are 1.5 times, jewelry stores are 4 to 6 times. Manufacturing operations will sell for between 3 to 5 times, depending on size and quality. Wholesale distributors in general can be bought for 1.5 to 2 times cash flow.



But You Are the Ultimate Judge of Value

However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you. Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.

One final observation: There is little geographic deviation in the value of businesses. A gift shop in Alabama is worth about the same as a similar one in California. What really counts more than anything is how well the business is performing financially.