Financing The Deal
Unless the person buying your business is absolutely flush with capital, they’re going to need financing in order to buy a business.
And, truth be told, even if you are flush with capital, some degree of financing is almost always the best route when acquiring a business.
In this brief article, we’re going to look at four ways you can finance the deal. It’s important to remember that you aren’t limited to using only one of these methods - most business acquisitions involve multiple sources of financing.
We’re looking at financing from a buyer’s perspective. It’s important as a seller to understand the forms of financing a buyer can obtain, in order to:
Ensure the deal will go through
Understand the obligations the buyer might expect of you as the seller
Better understand the mechanisms by which you might receive payment, such as earn-outs
Vendor take back
Vendor take back (VTB), sometimes called vendor financing, is one of the most important sources of financing for business acquisition. It’s so important, in fact, that many banks will only agree to finance a purchase if 10-25% of financing is through VTB.
So what is VTB? Quite simply, it’s a loan from the seller of the business. By securing VTB financing, the buyer ensures that:
The vendor still believes in the business (as VTB usually has a payment postponement period)
It keeps the vendor invested in the success of the business (so the buyer can rely on their expertise when needed)
We could go on about the benefits of VTB - and we may, in another post - but now let’s look at the mechanisms that allow for VTB to exist.
General Security Agreements (a corporate guarantee) are used to secure funding and describe what assets will be used as collateral. Promissory Notes (a personal guarantee) are used to ensure that the loan will be paid back in a timely manner.
As the business seller, you’ll almost certainly need to offer a loan of 10-25% to the buyer, and it will be secured that you receive the future payment.
Earn-outs
Earn-outs are similar to VTBs, in that the vendor of a business is paid out after a business is sold. They are distinct, however, in that they are not a loan - instead, they are a mechanism by which the buyer may reduce the initial price of a business.
The structure of earn-outs can vary widely depending on the transaction, but the fundamentals of earn-outs are typically the same. When particular performance thresholds are met, the buyer must pay the seller from the profits of the business.
This financing mechanism is typically used when a seller and buyer disagree on the price of a business - because they’re tied to performance, the seller only gets paid if the business performs well.
As the seller, if you know that the business is worth more than what the buyer is willing to pay, but you feel that the buyer is otherwise a good fit, earn-outs can be a great mechanism of recovering the difference in price. Through a combination of purchase price paid at closing, and earn-outs, you’ll sometimes make more money than what you wanted to sell for initially.
Borrowing from banks: The BDC or charter banks
The Business Development Bank of Canada (BDC) was created in order to finance businesses - and that includes the purchase of a business from a vendor.
There are a lot of advantages to the BDC. They offer a ton of resources and ongoing support, and their lending thresholds are often lower than those of charter banks. That means the buyer can purchase a business with less collateral.
The BDC does have one disadvantage, however - its interest rates are often quite a bit higher than those of charter banks.
If the buyer does have assets for securitization, charter banks may be the way to go. They offer lower interest rates. However, the payback terms are often much stricter with charter banks, so it’s important that the buyer is sure they’ll be able to turn a profit within a given time frame. A good business broker will work with the buyer to assist in this process.
Private lenders
Typically, private lenders offer financing in the form of interest-only loans. With this form of financing, monthly payments can be quite low, as they only go toward the interest. The interest rate is, however, typically higher than those offered by banks, and the principle must still be paid off eventually.
Private lenders can be a good option if the buyer’s finances are overextended, but they’re confident they can quickly turn a profit and repay the principal.
Now you know how the buyer can finance a purchase; there are many financing avenues available, which are touched on in the case studies. Many of which involve direct input from you, the seller.