What You Should Know When Financing a Business Acquisition
Whether a purchaser is an employee, minority owner of a small business, or merely seeking a new business opportunity, financing options for the purchase and sale of businesses have always been an obstacle. While existing owners may seek to retire or begin new business ventures, the lack of available financing has stymied their goals. This is because most businesses lack sufficient collateral to secure the financing. Unlike commercial real estate, which has a readily available market for financing options due to the strength of the collateral, most of a business’ value is in the goodwill of the company and not the hard assets. As such, lenders do not feel that their loans are adequately secured, and unless the purchaser has sufficient collateral outside of the business assets, conventional financing may not be available.
The good news is there is a commercial loan product available for such financing through the U.S. Small Business Administration SBA 7(a) government guaranteed loan program. Lenders who participate in this program can make loans up to $5 million to finance the purchase of a business. Lenders are willing to make this type of loan because the government guarantees repayment of 75 percent of the loan in the case of default.
Determining the Down Payment and Repayment Terms
SBA loans also have the added benefit of requiring less of a down payment than conventional loans, although in the business acquisition setting, the down payment may need to be increased based on the value of the intangible assets. The first step in determining the required down payment is to order a business valuation that supports the purchase price. The valuation will include a determination of the value of the assets, differentiating between the value of the hard assets and the intangible assets. If intangible assets exceed $5 million, then the down payment must equal 25 percent of the purchase price, either through funds from the purchaser or seller take back financing with terms providing that no payment on the take back portion of the purchase price may be repaid for a period of two years. While a seller may not be thrilled with the thought of deferring some of the purchase price, given the lack of available conventional financing, most sellers are willing to defer a portion of the purchase price to consummate the deal. There are also limited circumstances where a lesser down payment may be required. However, such decisions must be made by the SBA directly and not the lender. Furthermore, the repayment terms after the two year standstill period must be justified under a cash flow analysis. If real estate is also involved in a business acquisition, the 25 percent down payment includes the value of the real estate. The real estate may not be removed from the transaction to avoid the 25 percent equity injection requirement.
Defining the Co-Borrower or the Guarantor of the Loan
In all business acquisitions (excluding certain ESOP purchases), the principals involved in the purchase must either guaranty the loan or become co-borrowers. In a stock sale, the business being purchased and the purchaser are co-borrowers. Where there is a partner buyout (one or more existing owners are buying out all of the other owners and the sale is consummated as a stock redemption), the purchaser(s) may either be a co-borrower or a guarantor of the loan. In asset sales, the principals will be guarantors of the loan. If an existing business purchases another business, the existing business may be the borrower or the existing business and the acquired business may be co-borrowers with the principals of the business guarantors of the loan.
It is important to remember that in order to be eligible for an SBA loan, the result of the sale must be 100 percent ownership by the purchaser. Minority owners in a business not involved in the purchase also must exit the business upon its sale. The SBA allows a seller to remain (as a consultant) for up to one year to allow for the orderly transition of the business. However, once the sale is completed a seller may not remain as an officer, director, stockholder, or key employee of the business.
When financing business acquisitions, lenders also may include loan proceeds for closing costs and working capital. There are also other eligibility requirements for SBA guaranteed loans that must be adhered to. A review of the SOP 50 10 5(G) will identify all other eligibility requirements.
Alison Rind is an attorney at Lerch, Early & Brewer in Bethesda, Maryland. She represents commercial lenders in loan transactions and other commercial matters, including participants in SBA and other government-guaranteed lending programs. For more information about financing a business acquisition, contact Alison at (301) 657-0750 or firstname.lastname@example.org.