I have several clients that are involved in business acquisitions. With a sluggish economy, many are attracted to the opportunity to acquire business versus grow organically. If you’re deciding to buy a company, here are 3 things you must know about financing the acquisition.
1. Many buyers want an asset purchase because they get a step up in the basis of the assets. The difference between the purchase price and the assets is considered goodwill and is amortized (non cash expense) over time. Because goodwill is an intangible asset, the bank will request you collateralize the goodwill with tangible assets like receivables, inventory, equipment or real estate. If the business does not have sufficient assets to fully collateralize the loan (remember the bank has a margin requirement on all assets), then the owner may need to pledge personal assets to cover any shortfall as part of his/her guarantee.
2. Don’t expect the bank to finance 100% of the purchase. Just like buying a building, the bank expects 20-25% equity and they finance 75-80% with their loan. In prior articles, we have talked about leverage. When you borrow 80% and you put in 20%, you in effect are creating a leverage ratio of 4-1 (80/20 = 4), if you put in 25% it’s 3-1 (75-25). Banks get uncomfortable, when leverage is above these numbers.
3. The best bank product to use for a business acquisition is the SBA 7a loan. It’s a term loan for up to a 10 year period, rate is a variable rate that floats with Prime, usually 2.5%-3.5% above Prime. Most banks don’t finance acquisitions on a conventional basis and even if they did the term wouldn’t come close to 10 years, likely 3-5 years because the goodwill. The SBA provides a 75% guaranty back to the bank if the loan is in default and has to be liquidated. There is a fee for the guaranty of about 3% that is paid to the SBA and can sometimes be financed in with the loan. The SBA requires a minimum of 20% equity, 10% of that in cash with the other 10% in cash or subordinated seller financing.
The SBA 7a loan is the bank’s product of choice for any acquisitions that are financed with bank debt. There is a cap of $5 million under this program.