How to Finance the Purchase of a Business
When the owner of a company sits down to discuss with a potential buyer the sale of his business, he must bear in mind the various financial formulas that could eventually be applied to the operation. An expert in finance would say that to close some businesses you have to “get creative.”
Since the ideal situation of payment through “a single check” does not always manage to crystallize in all business transactions, we will analyze some alternative cases here.
Bank financing
The Great Recession that began in 2007 and started to ease in 2011, left a clear lesson to American businessmen in relation to the use of bank credit. There were many stories of bankruptcies and even suicides generated by this fateful period of our contemporary economic history.
The mistrust of the business community, together with the government’s restrictions on the banks’ financial activity, substantially reduced the debt dynamics that existed before the recession. Nowadays, banks feel comfortable only when they finance companies that have a large collateral in assets, solid cash flow, good profit margins and owners willing to grant their personal guarantee.
However, although traditional banking formulas have taken a back seat in business preferences, Small Business Administration (SBA) programs continue to drive innumerable small and medium business projects. Thus, under the program known as “7 (a)” the loans granted by banks with SBA endorsement can reach up to $ 5 million without an established minimum.
The SBA guarantees a maximum of 85 percent of loans of up to $ 150,000 and 75 percent of loans exceeding $ 150,000. SBA will not guarantee amounts over $ 3.75 million.
For loans of $ 150,000 to $ 700,000, the rate is 3 percent. For loans of $ 700,000 or more, it is 3.5 percent. For loans over $ 1 million, there is an additional charge of 0.25%.
Interest rates are negotiated between the applicant and the lender but cannot exceed the SBA maximums. Payments are made monthly and include a combination of principal and interest, as in a traditional loan. (www.sba.gov)
Seller Financing
Given the banking restrictions, the seller’s finance appears as an excellent alternative to take the sale of a successful business. Thus, the buyer pays an initial fee ranging between 20% and 50% of the amount and signs a promissory note for the difference in the purchase price.
The promissory note must stipulate the guarantees granted by the buyer and set the payment terms. In operations of small and medium enterprises, the term can range between 2 and 5 years and the interest rate between 5% and 10% per year.
There are several benefits that arise for the Seller and the buyer in these transactions. The most notorious are the following:
1. The closing time of the operation is shortened because the bank evaluation process is eliminated.
2. It is possible to substitute an eventually negotiated reduction of the sale price for the granting of terms to pay.
3. The seller dilutes the profit from the sale between various fiscal periods.
4. The seller obtains better interest on the balance than those paid by the bank.
5. The buyer can access the operation with fewer resources.
6. The buyer’s rating is made by the seller and not by the bank.
7. No point payments, origination, appraisals, credit reports, title insurance and other fees charged by conventional lenders are contemplated.
The seller’s financing is usually guaranteed with the assets or with the shares of the company if it is a corporation. When assets owned by the seller are given in guarantee, a UCC-1 (Uniform Commercial Code-1) financing statement must be completed to give the public assurance that the seller has a claim against the buyer (www.floridaucc.com).
Conclusions
Among the available options on how to finance the purchase of a business, it is important to estimate “a priori”, in detail, the capital requirements and, of course, take into consideration that each new business must reach its equilibrium point (Income=Expenses) in a timely manner. The glorious moment in which the income exceeds the expenditures will depend on the successful planning of the future that the buyer has estimated.
It will be then the creativity of the buyer the fundamental element for its business success. Here, Peter Drucker once said: “The best structure will not guarantee a good performance, but the wrong structure is a guarantee of failure.”
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Author: Alfredo Gonzalez I alfredo@xl-bb.com
