A lot of people make the mistake of not considering the financing part of buying a business early enough in the process. They go about their search thinking that they will address the financing when they find a business. This is the wrong approach, and probably means they will never buy one.
Arranging financing is as important as finding a business, perhaps more so. It’s very simple: no money, no business - unless you are planning to pay all cash. However, I won’t let you consider that, even if you have the funds! It’s too risky and there are always other options available.
What is seller financing?
Your goal is to avoid guaranteeing 100% of the financing, and allocate your funds to growing the business. What you ideally want is to find a business you can buy with Seller Financing. This is when the owner of the business acts like a lender and finance part of the sale price, which you pay back to them using the profits of the business after you take charge.
Financing a good business is ALWAYS possible. There is a person or institution somewhere that will lend you the money, if the business has demonstrated its financial viability in the past. Your job is to convince the lender that the future is bright, and you are the right person for the job.
What do I need to get funding to buy a business?
When you seek funding, you will have to provide a Personal Financial Statement. You will be asked for these at all stages. The broker may want to see one to ensure you are not wasting his or her time. The owner may also require you to produce this as part of the pre-qualification process. Any person or institution that may consider lending you money will require this.
When you do your PFS, do it with complete honesty. Do not hide or embellish any facts. Even if the numbers are not attractive, you must present the truth. You should attach copies of all relevant documents (bank statements, stock account statements, mortgage payment stubs, tax returns). It is also a good idea for you to attach your credit rating sheet.
What options are there to get funding to buy a business?
There are so many different lenders, it’s a wonder that anybody is ever refused a loan. There are lenders that will finance based on the assets, receivables, future billing, real estate, the business itself, cash flow and more. They come in all shapes and sizes, but the greater the risk they believe they are taking, the greater the cost to you.
There are three financing options available to you: debt, equity and debit to equity. Debt is most commonly associated with loans. You borrow money, you owe it to someone and you have terms and conditions by which you must pay it back.
Equity financing is a method by which money is provided, but instead of the lender being paid back with a payment schedule, they receive a percentage of the business and are paid back through the profits of the business. With Equity Financing, the lender shares both the risks and the benefits.
Debt to Equity is a method in which a loan is made, but there is a mechanism by which the Debt can be converted into Equity. You probably will not come across these situations often, but it is one to consider. Let’s take a brief look at the pros and cons of each.
What are the pros and cons of debt and equity financing?
Many people consider debt financing to be a less expensive option than equity financing. As long as you make the payments, once the debt is repaid, there are no further obligations. If you are unable to make the payments, however, you could lose whatever you used to guarantee the debt, such as your house, inventory, receivables or the business itself. Debt financing is generally easier to arrange and there are tax advantages to straight debt since the interest paid is considered an expense.
Some people believe that equity financing is a more expensive form of financing than straight debt, but I don’t agree. Their logic is based upon the fact that with debt financing you know in advance exactly what the loan is going to cost each month and in total.
With equity financing, however, you use the money your investors paid for their shares to fund the activities of the business. As you build the business and profits grow, so too does their return. They will continue to reap the benefits unless you buy them out at some point. Personally, I don’t see much of a downside and believe that equity is the better option if you can get it.
If you do go down the equity route, though, you must ensure that no matter how much they invest, you must own more than 50% of the company. Not 50/50, but 50.1% at least. When a business is owned 50/50, it can lead to paralysis. One of the benefits of business ownership is having control over your own destiny. If you go the route of equity, you must not let this evaporate - you must have the final word.
Recourse loans vs non-recourse loans
If you opt for debt financing, there are two kinds of loans you should know about. A recourse loan is a loan in which the assets of the business are used as collateral but you and/or the business are responsible if payments cannot be made. Conversely, a non-recourse loan is where the lender cannot come after you personally for any shortfall between the amount owing and the assets pledge. Here is how each works:
The business has a loan where it has pledged certain assets as collateral. For example, you owe $75,000, with the company’s machinery used as collateral. If the business is unable to pay the loan, the lender can seize the machinery. When they sell the machinery, if it only brings in $50,000, there is a $25,000 shortfall. In a recourse loan, you, the business owner, are personally responsible for this $25,000 difference.
With non-recourse loans, you have zero exposure. Certain assets may or may not have been pledged, and if the business defaults on the loan, the lender cannot come after you personally. It makes sense to have this clause in any loan that you may have, but this is easier said than done. As you can understand, a Non-Recourse Loan may have a higher interest rate to justify the lender’s additional exposure and this type is much more difficult to negotiate.
Why seller financing is the best option, by far
I spoke earlier about seller financing, but I’d like to return to the point here to hammer home why I think it is the best option for financing, by a long distance.
Your opportunity to negotiate a favourable loan will be best served when you do so with the seller. I will even go so far as to say that your initial search should be limited to those businesses where seller financing is offered. Seller financing is your best option because:
- You can negotiate the best possible terms
- The seller has the incentive to finance you
- You can leverage the assets greatly with the seller
- The seller knows that this can save the deal
- If the seller does not provide financing, they are making a statement about their opinion of the viability of the business. Seller financing to me is like getting an extra warranty on a used car
- If problems are discovered in the business, you can always renegotiate with the seller. You have resource with the seller
- A reasonably informed seller (which can be a bit of a stretch), will realize that offering a Balance of Sale is a normal condition in these transactions
Other options for financing
If seller financing is not available and you can’t get a favourable loan from a bank, there are other options for you to consider.
Friends & Family Members
There is a lot to consider if your friends or family participate in the financing. First and foremost, you must realize that your relationships with these people will change and even in the best scenarios it may not be good. If you fail, they will be upset, and if you succeed they will probably never feel you thanked them enough. Be very careful when considering this option.
Angel Investors
These are individuals who will lend money to businesses in their early stages. There are lots of people around that have plenty of money. The key is to locate them and present your case. They can help get you going, and they generally want to have an equity position. They want a big upside: they have money, so they can afford the risk.
Professionals
I love this one! After you hire an accountant and lawyer and establish a good rapport with them, you should raise the idea of having them participate in the financing for a piece of the business. When you hire an accountant, don’t be afraid to work with a smaller firm. You will get their full attention, the fees will be lower, and they may be able to help with the financing. The same applies to lawyers. They do not often get the opportunity to own businesses and many attorneys would love the chance to get into business.
Asset-Based Lenders
There are lenders that will lend money based upon the assets of the business. For example, they will provide financing against your accounts receivables, inventory and equipment. They will discount these Assets to ensure that their exposure is limited. Remember they are professionals, so don’t think you will fool them on the value of the assets.
Leasing Companies
These companies will “buy” your equipment and then lease it to you. While this may be difficult for the actual purchase of the business, you should consider this afterwards to raise money and for future purchases.
So, there you have it: all of the possible places to go and get money and all of the conditions to consider. Unfortunately, no one will just give it to you. If they do, get me their number!
This article has been adapted from How To Buy A Good Business At A Great Price, a course written by Richard Parker at RichardParker.com. To gain access to the full course, which walks through the entire process of purchasing a business and breaks down these negotiation tactics in further detail, click here.
