Authored by: Benjamin Misner
DISCLAIMER: This article is meant for educational purposes only and is not intended to be construed as financial, tax, or legal advice. iGOTHAM always encourages you to reach out to an advisor regarding your own situation.
There are many blogs and articles on the Internet that give many examples of how to fund/finance a business purchase. While most of these articles give good ideas on financing a business purchase, many of them don't give you any actionable resources or key steps on how to go about the process.
Not only is the time required to find a business to buy quite intensive, but so is the capital raising process. There is a multitude of options when it comes to sourcing financing for a business acquisition. While there are lots options and financing strategies on how to acquire a target company, this can make the process even more confusing.
This article will aim to make the capital raising process less confusing as well as give you a multitude of options, examples, and key tips that you can add to your investor tool kit when raising money to buy a business.
This article will be the most comprehensive and detailed guide to raising money! So, grab that energy drink or cup of coffee, and let's raise some moneyyyy!!
SBA loans are made by banks to businesses, and they offer competitive loan terms and low-interest rates compared to conventional financing options. However, borrowers must meet strict criteria before receiving approval.
You can apply for a Small Business Administration (SBA) loan through a lending institution such as a bank or credit union, which then submits an application for a loan guarantee to the SBA. If you default on an SBA loan, the federal government pays the lender the guarantee amount.
The SBA requires an unconditional guarantee from every person who owns at least twenty percent of a business. This guarantees both the borrower and his/her property against loss if the borrower defaults on the loan.
Both the government guarantee and the individual guarantee lower the risks for lenders—making them more willing to lend money to small businesses. Once you're approved for an SBA Loan, your lender is responsible to close the loan and distribute the funds.
While there are multiple types of SBA loans, the most common is the SBA7(A) loan. With the SBA7(A) loan a business acquirer can get up to $5 million in acquisition financing.
Some of the financial documents you should collect are the income statement, balance sheet, and cash flow statement for the last three years. You should also obtain any year-to-date financials. Other financial information to collect will be the accounts receivable and accounts payable info, a list of all bank accounts and bank statements, and business and capital budget plans as well as the last three years' tax returns. Make sure to have an QOE (Quality of Earnings) expert review the financials.
On SBA loans, interest rates are made up of a base rate and a percentage added on by the lender. The base rate can fluctuate over time and is often based on the prime rate, LIBOR, or the optional peg rate. Because interest rates are limited by SBA maximums, applicants can still afford SBA loans.
The SBA has strict caps on fees that lenders can charge when originating an SBA loan. Starting October 1st 2022 the fees for some SBA7(a) loans will be changing.
Starting October 1st, 2022, the fees on some SBA7(a) loans will be changing.
The SBA guarantee fee is the main fee involved in getting an SBA loan. And it is charged only on the guaranteed portion of the debt.
This is what some of the fees have been for years:
Up to $150k: 2% Fee
$150k-$700k: 3% Fee
$700k-$1million: 3.5% Fee
This is what the fee structure will be changing to starting October 1st, 2022.
Up to $500k: 0% Fee
$500k-$700k: 0.55% Fee
$700k-$1mm: 1.05% Fee
There will be no changes on the fee structure for over $1mm.
Under 15 years.
Down payments on SBA loans can be as low as 10% of the purchase price.
Below is more detailed info on the required documents needed to submit for an SBA loan.
Small Business Administration (SBA) loans come with some of the strictest underwriting requirements that small business owners can face, including a credit score of 680+ and strong personal and business financial history. While the SBA does not make the decision about whether or not an applicant will get approved, they do play a major role in determining how much money an applicant is eligible for. To qualify for an SBA loan, applicants must also show proof of having started their business within two years before applying for the loan.
If you are worried about the potential of default on an SBA Loan you can get personal guarantee insurance in case the business goes under. You can get personal guarantee insurance through several insurance agencies. For example, Burns and Wilcox offers several business insurance solutions including personal guarantee insurance on an SBA loan.
SBA loans are primarily advantageous to self-funded searchers. If you get qualified for an SBA loan this could save you time from having to find outside equity investors or other conventional lending providers. An SBA might make sense if you are looking to acquire a smaller business with revenues below $ 10 million. One of the most common banks used by self-funded searchers to obtain an SBA loan is Live Oak Bank.
If you want to save time when getting approved for an SBA loan during the acquisition process, you can get pre-approved for an SBA loan from Live Oak Bank. A pre-approval letter from your SBA lending institution could help you close the deal faster once you get an opportunity under LOI. Sellers will also see you as more of a viable candidate because you already have your financing lined up.
If you are not using an SBA loan, you will most likely be using an acquisition method called an LBO or Leveraged Buyout. A leveraged buyout is a firm that uses a small amount of equity and a large amount of debt financing to acquire a company, division, business, or collection of assets. The acquiring company uses the debt to increase its equity and to reduce the risk of the overall acquisition. Simply speaking, using leverage (debt) increases the private equity firm's expected returns. Investors can obtain a high return on equity (ROE) and internal rate of return (IRR) by investing as little of their own money as possible, assuming everything goes according to plan.
Using conventional loans is most common if buying a business for over $ 5 million. The types of loans that business buyers can get would be based on specific collateral of the target business. There are two types of conventional-based lenders, one type makes loans on specific assets of the business or commonly known as "asset-based loans" and the other is called "cashflow" based lending. Some lenders can offer both types of financing.
Below are some of the most common types of conventional financing that you can use when buying a business.
When banks are looking to provide financing for a business acquisition they will look at what in the business they can loan against or "collateral". One of the common pieces of collateral that a bank will loan against is the asset base of the business.
Below are some of the common asset-based loans you can get.
Accounts receivable is on the balance sheet of a business and are deemed "short-term assets or current assets" on the balance sheet. Accounts receivable is the value of the individual customer's outstanding invoices that have not been paid to the company yet. It is essentially a credit line that has been given to its clients.
A financial solution where a company uses its inventory as security for loans. An example of this is if you are buying a consumer goods product business. Inventory is any product, material, supply, or part held by a business for sale or use. There are four main categories of inventories: raw materials, work in process, finished products, and MRO (maintenance, repair, and operations). The terms on inventory-based loans are usually short compared to other types of asset-based loans
Most of the financing we have covered above is with regards to tangible collateral used as a method to get financin*g. Intellectual property is financing on the intangible assets of the business. Some examples of the types of intellectual property lenders lend against are Patents, trademarks, or copyrighted works. An example of an industry where intellectual property financing is prevalent is in the biotech or pharmaceutical industry. Intellectual property loans are usually secured by royalties from the use of licensed intellectual property rights. For example, if you own a patent for an invention, then you could secure a loan against future royalties from the sale of products using that patented technology.
In summary, these are the common types of assets that lenders will lend against when financing a business acquisition.
Here are some asset-based lenders:
2. Lendio
Revenue-Based Financing (RBF) is an alternative method of funding a business acquisition. You can apply for a loan against your future income stream. . Revenue-based financing works well on companies that don't have the collateral for a traditional loan. Revenue-based financing (RBF) is used by companies with high gross margins or subscription-based revenue models as an alternative to traditional equity funding. For example, SaaS businesses often use RBF to fund growth because they typically have higher gross margins than traditional brick-and-mortar retailers. Companies with steady MRR can also benefit from RBF because they can leverage their existing customer base to raise money.'' By contrast, revenue-based finance combines the best characteristics of debt and equity. It provides funding in exchange for a share of future profits. There is no loss of control by shareholders, but there is greater financial exposure than traditional debt. Businesses typically borrow between $50,000 and $3 million, depending on a variety of variables, such as their ARR or MRR. ARR refers to how well the business is expected to perform in the future, whereas MRR refers to how well it has performed in the past Most investors usually limit loans to a third of the companies' annual revenue (ARR) or four to seven time their monthly recurring revenue (MRR). The lender will then determine the loan amount by taking into account a payment cap, which is typically between 0.4 and 2x the principal investment, but may vary depending on the business. The monthly repayment percentage usually ranges from 2% to 3%, but it can go up to 10%. The repayment cap is meant to replace charging an annual rate of finance. As you might expect, the income-based financing model is especially useful for businesses based on SaaS or recurring subscriptions.
Business Lines of Credit (BLOCs) are not often used as acquisition loans. However, in certain situations, they can be ideal for this purpose. These loans are revolving, meaning that once you are approved for up to a specific amount (your credit limit) you can borrow that money any time you need it during your loan term.Once you draw against your line you only pay interest on what you borrow (monthly interest-only payments). An example of when to use a business line of credit for a business acquisition would be if you already have a business that you own. A lender would extend you credit based on the current revenue stream of your existing business, which you could use to finance the purchase of another one.
Below are some cashflow based lenders:
1. Kabbage
Revenue based lenders:
1. Arc Technologies (They offer acquisition financing for SaaS companies. They convert future revenue into upfront capital without dilution)
2.Uncapped
3. Ampla
With conventional-based financing, the borrower does not need to offer his assets as collateral in case of default if the EBITDA of the business is north of $1.75 Million.
With conventional financing, you can negotiate a multitude of deal structures such as earnouts, and the length of the seller staying on board as a consultant. Etc.
Conventional-based lenders can offer a higher loan limit than compared to government-backed loans.
With conventional-based financing, you will need to bring in more equity than compared with an SBA. Lenders will usually need to see a minimum of 20% down.
With conventional financing, you will need to be acquiring a business that at least has a minimum of three years of financial history.
Interest rates are usually higher than compared to an SBA loan.
Whether you are using an SBA or conventional-based term loan there is a multitude of pros and cons. What it comes down to is if you have funds backing you or you are self-funded.
If you are planning on financing an acquisition mainly using your proceeds and the purchase price is below $5 million then an SBA might be a favorable option.
If you have other people's money backing you and you are planning on acquiring a business for more than $5 million then a conventional-based loan might be the better option.
If you are getting conventional financing, here is a list of some top QOE recommended providers:
1. Plante Moran
2. Hood and Strong
3. Mallory and Associates
4. Boulay
Another common way of raising capital is raising money from other people. These people could be friends or family, other people you may know in your network, or accredited investors.
In this section, we will focus primarily on raising capital outside of your network from a variety of sources.
If you don't have a network already of wealthy people to call upon when raising capital. There are a couple of ways that you can track down equity investors. One way you can attract outside capital for your acquisition is by using investor.com. Investor.com allows finding equity investors based on industry, investor type, size of funding, and location. They also provide the contact info necessary to get in touch with the investors.
Here are some other platforms you can check out to raise money from individual investors:
2. Equity Net
Another way to raise money is to partner as co-GPs (general partners) on a deal with a PE firm. An example of how this would work is, let's say your investment firm is looking to acquire plumbing companies in the state of Texas. After months of searching, you find a plumbing company that is willing to sell to you and now you have the plumbing company under LOI (Letter of Intent). Once you have an LOI signed by the seller, you can shop around for another potential partner for the deal. A creative method would be to create a list of other private equity firms that have bought similar plumbing companies in Texas and tell them about your deal and explain the terms you negotiated and the proposed deal structure to see if they would be interested in partnering up on the deal.
Often, a wealthy person or family creates their fortune through having domain knowledge in an industry. This knowledge can be applied to running a business, creating valuable relationships, or simply thinking strategically. By setting up a family office, the owner can maintain some degree of influence over his or her assets and also help to generate additional value once they're invested.
A typical investment timeframe for a PE fund is 7–10 years. However, some families may hold investments for even longer than that, due to the long-term focus of a family office.. Therefore, holding periods can vary from one generation to another.
There is no shortage of money currently being managed by family offices. According to CNBC, over $6 Trillion is currently being managed by family offices worldwide.
A great resource to find family offices looking to invest capital would be the Family Office Database.
A common form of financing used by buyers in an acquisition is "Sellers Financing." Sellers typically provide a loan to buyers who want to buy their businesses. Buyers pay back the loans in installments, with a percentage of each installment going towards paying off the loan. Essentially the seller acts as a bank and carries a portion of the note which the buyer will pay over time.
Seller Financed deals are common among small businesses because they allow owners to purchase a company without out having to put up a ton of money upfront.
The benefits to the seller are that it allows them to have a continued income stream over an extended period while allowing the seller to defer capital gains.
The benefit to the buyer is that it allows him to minimize the number of personal funds he needs to put down, which allows the buyer to maximize the capital in the acquisition. The less money the buyer needs to put down the higher the return. Seller financing also allows the buyer more flexibility to negotiate the interest and the loan terms, which can help the buyer craft a more favorable deal structure.
Let's say Jack wants to buy a plumbing company from Nick. Jack will primarily be using an SBA loan to help fund the purchase of Nick's business. The minimum down payment on an SBA Loan is 10%. After a fair amount of negotiation, Jack agrees to buy Nick's plumbing business for $1,000,000. Jack then gets approved for an SBA financing, BUT... Jack only is only able to do a 5% down payment on the $1,000,00 purchase price. ($50,000/$1,000,000). Jack will have to find an additional $50,000 to meet the SBA requirements of a 10% ($100,000) down payment...
What are Jacks options??
1. Raise money from friends/family (but Jack doesn't have friends or family with money 😰)
2. Ask for seller financing from Nick
3. Find another investment firm to partner with on the deal
4. Use a combination of #2 and #3.
Jack decides to ask Nick for 50% seller financing. Nick says no, but Nick eventually agrees to a seller note of 10% of the purchase price. This is great because seller financing can be used as part of the initial down payment!
Jack is now able to meet the minimum 10% down payment requirement with the seller providing 10% standby seller financing on top of his 5% cash infusion. Jack can put a total of 15% down.
A claw back is usually a key contractual provision that is included in seller financing. A claw back provides security to the seller for the shares you have not yet paid for. For example, let's say you buy a company for a total of $10 Million. You pay 60% upfront for the business using some of your money as equity and the rest is conventional financing. The remanding 40% will be in the form of a loan from the seller. Every time you make a seller financing payment, the claw back rate lowers.
If you default on your payments the seller has the right to collect the percentage of outstanding shares that you can't make the payment on.
When negotiating seller financing, make sure that you don't personally guarantee the debt with your personal collateral. Make sure the lien is on either the assets or shares of the business. That way you are not personally on the hook for repaying debt in case of default. In case of default on seller finance payment, the seller would file a UCC filing stating his claim to the outstanding shares/assets of the business.
An earn-out is a type of contract where the final amount of the sale is either wholly or partially contingent on the company's performance over a specified period after closing. Typically, the purchaser will be obligated to make payments to the sellers based on pre-agreed-upon revenue milestones. If the company does better than expected, the buyers will owe the sellers more money; if the company does worse than expected, the buyers may owe the sellers less. Earnouts can be used to incentivize companies to perform well during the transition period between selling and buying. Earnouts allow the buyer and seller to bridge a valuation gap and structure a deal that can benefit both parties.
They can usually be quite a lot of debate on whether seller financing or an earn-out is the best method of financing. Earnouts are significantly used when there is a level of doubt regarding the future cash flows from the target organization.
Some examples of when to use an earnout are if you are buying into a cyclical industry, the target company is launching a new product, the target company is awaiting FDA approval (biotech, pharma), and the company is entering a new market, the target company is a niche business with the unique customer base.
How can earnouts be structured?
Earnouts can be based on any number of metrics, revenue, sales, profit margins, customer satisfaction, product quality, market share, brand awareness, and so forth. They're typically tied to financial milestones such as hitting specific revenue goals, earning a particular amount of net income, reaching a certain percentage of annual revenues, or achieving a certain level of profitability.
Jason wants to buy a profitable Amazon FBA business from Tim. The Amazon business sells low-end sunglasses. Tim's business has been around for two years and according to last year's projections, it made $1,000,000 in revenue. The seller also believes that his company can double revenue in the next five years and do $2,000,000 in revenue. Tim wants a higher multiple for his business because he expects tremendous growth. Tim wants a total of $3,00,0000 for his business. Jason on the other hand is only willing to pay $1,500,000.
Although Jason would be willing to pay a higher multiple for this business if it had more of an established track record, there are some risks he is concerned about, such as the company has only been in operation for two years, lack of customer acquisition channels, Amazon can suspend or ban your account at any time, changes in Amazon can introduce in the algorithm could pull down some of the store's products.
Hence, there is now a gap in the perceived value of the business between the buyer and seller. Both Tim and Jason are now in a deadlock negotiation and it looks as if there will not be a deal.
Faced with these risks, Jason still wants to go through with the acquisition but decides to use an earnout to craft a win-win deal structure. 💡
Jason agrees to pay the $3,000,000 with $1.5 Million going to the seller at the close, and holding back the additional $1.5Million until the business reaches the projected revenue milestone of $ 2 million a year. Essentially Jason and Tim agree to shift part of the purchase price to be paid in the future once the target company reaches $2 Million in top-line revenue.
This is a simple example of an earnout structure and can vary by the deal and be quite complicated.
A home equity line of credit could be a beneficial type of acquisition financing. If you own your home outright or you have equity in your home, and good personal credit, you can apply for a Home Equity Line of Credit (HELOC). Banks typically charge lower interest rates than traditional loans, so if you plan to borrow money for a short period, a HELOC might make sense.
To get approved for a HEL you may need a credit score over 660 or greater. Lenders typically offer between 90% and 95 percent of the value of your house.
As with all loans, there are certain risks. It is important to remember that a HELOC is a secured loan against your home. If you run into trouble paying back the loan you could be without a house.
Hopefully, this article gave you the key insights and tools to assist you when looking for acquisition financing. From SBA financing, types of conventional bank loans, seller financing, earnouts, etc.
If you are looking to acquire a business one of the first steps you can take is by getting pre-approved by lenders.
You can start identifying lenders that you would want to use for acquisition financing and have conversations regarding the process, what to expect, and what they would need from you when the time comes.
Here at iGOTHAM we help acquisition entrepreneurs, private equity firms, and family offices source acquisition opportunities.
Set up a meeting below to learn how iGOTHAM can help source acquisition opportunities for you.
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