Financing the purchase of a business

Financing the purchase of a business

Purchasing a business isn’t like buying a house. There have been many financing options in the past few years where buyers could purchase a house with zero down. That just isn’t possible when buying a business. So if you have a dream of being your own boss some day, start saving now!

Typically, and in the current environment there isn’t anything really typical these days, but generally a bank will be looking for 20% to 30% down. That can vary greatly based on the following;
• How much of the purchase price is Goodwill vs. Assets
• Experience of the Buyer in that industry
• Seller willing to carry any debt on the business sale
• Industry
• Cash flow of the business
• Tax records of the business
• Credit worthiness of the Buyer
• Is there Real Estate involved
• Collateral

Combinations of the above can really change the financing landscape. Let me outline some common combinations that work and don’t work.

We (Business Brokers) often encourage owners of businesses to finance some or part of a business acquisition. There are several good reasons to do this;
• Buyers have confidence that the business is good since the Owner still has some skin in the game. Banks like this too.
• Sometimes the SBA departments in the banks will consider Owner financing to be almost the same as Buyer cash in the deal to. This means that a Buyer could put less down, maybe as little as 10%.
• There are tax advantages to Owners when they finance part or the entire sale. They may be able to defer taxes until they actually receive the payments in future years.
• There is the added “boot” of interest income from the financing. Also risk.
• Lower down payment requirements for Buyers open the door to more candidates which helps the business sell faster and at a price favorable to the Owner.

Goodwill isn’t where you take your old clothing to donate, well yes it is, but not in this instance. I’ll explain Goodwill and tax issues in a future article, but for now let’s consider Goodwill as it relates to a bank loan.

Banks like “hard” assets. Something tangible. Something they can reposes it all goes wrong. Inventory can move out the door to quickly, so banks aren’t big fans of inventory as collateral in buying a business. Accounts Receivable (A/R) is discounted depending on the quality and age of the receivables. Banks like bricks and mortar, equipment, etc.

Goodwill is an intangible. You amortize goodwill, you depreciate equipment. Similar, but very different. Basically a business has value based on the cash flow of the business. Think for a moment about a computer. On eBay, you’d get two cents for a used one. If that same computer was on the desk of a key employee, imagine the revenue lost if it were gone. Not priceless, but it has a lot more value than the one on eBay. Same computer, different uses. So you could say the difference the two computers is from the “goodwill” that is created by an ongoing business.

The Goodwill is the difference between the fair market price of a business and the total of all the other assets of the business. Assembling all the employees and training them costs lots of money, they are included in the goodwill. So if a business fails, all the employees are gone, and all the profit, and it leaves you with the hard assets, which are about two cents. Now you know why banks don’t like goodwill. Today, SBA loan underwriters like to see seller financing equal to the goodwill of the business. Not a rule, a guideline.

Of course, a Buyer must have some experience. If you’d like to own a restaurant but never worked in one, the bank will not loan you the money. If you have a felony conviction, you can’t own a bar. It’s that simple.

The SBA has also ruled out financing for C-Stores with gas. Too many failures and too many environmental issues with the gas tanks.

The business should have current tax records for that business. It the returns are blended with other businesses or locations, the bank will require that a full scale audit and accounting is made for the business unit being sold.

One last thing, the SBA is the Small Business Administration. They do not make loans. Most banks have a SBA loan department. The SBA will make guarantees to banks that follow their guidelines (exactly). The guarantee is for a portion of the loan and reduces the risk the bank has. This allows the banks to make loans and keep business and commerce going. Defaulting on a SBA loan costs all us taxpayers. The SBA to fund these loan guarantees sells notes on the market. These placements cost money and the high risk is expensive too. SBA fees are therefore higher when taking out the loan. SBA loans are typically 2% to 2.5% over prime, or the rate banks charge their best customers.

Hope this helps. Look for future articles on collateral, inventory, capital goodwill and several hybrid financing solutions.