How To Finance A Business Purchase

imgOn the first page of this post I mentioned a few businesses that banks might provide finance for using the business as their security.

That really is the easiest way to describe it, but to break it down further for you, I want you to think of a business in a couple of ways:

First, the business purchase price you are paying is usually a multiple of it’s profits. So you might be paying 3 times the profit of $300,000 to establish a price of $900,000. The multiple you pay is determined by how much risk you are willing to take by purchasing the business. Using this example at 3 times the profits, you are effectively saying that you are happy with a return of 33% (3 x 33 = 100) on the money invested. Another way you might hear this described is a 3 year payback. ie. the business pays back the $900K over 3 years. (this by the way is rarely true and a very simplistic way to look at things)

So, the price you are paying is multiple of Profit which effectively is CASH. It is NOT an asset. You see if the business has no assets and neither do you then all you have is a cash flow and the potential to derive a profit from that cashflow. Hence, when you arrive at the bank and ask for a loan of 60% of the ‘value of the business’ being an asset, they look at you quite strangely and then ask if you own a house.

Second, the assets of the business lay on the balance sheet and are usually:

  • Debtors
  • Plant and Equipment & Motor Vehicles
  • Property
  • Stock

These are really the only assets that the business has to offer as security to a bank. I’ll explain more on this later.

Think about this, you buy the business which is making a profit of $300,000 at the time. Somehow you reduce your profit to only $50,000 – what is your business worth now? 3 x $50K = $150K ? Believe me this is the best case scenario you could hope for. Usually in this situation it won’t be worth anything. So, what will a bank then sell to recover the 60% loan ($540,000) they gave you to buy this business?

This is why they want collateral (security) to cover their loans when you want to buy a business.

Now, is there only bad news? No, definitely not, there are ways to structure a finance package and borrow against the future cash-flow of a business.

These types of structures are usually put in place when a mix of security, net worth of the borrower and business assets are combined with a loan against the cash-flow of the business. It is the combination of all of these parts that makes for a successful loan application.

The world of financing has changed quite a bit in the last few years and so the numbers I’ll give you now might seem conservative. Believe me, they are real right now.

As a rough guide I usually look at being able to finance about 30-40% of the purchase price as a ‘cash-flow’ loan. This is the type of finance that people describe as ‘a loan against the business’.

So, let’s say your business purchase price is $900,000.

I would look for approx. $270,000 as the maximum amount of loan that would be established against the business. This amount might be available if the net worth of the borrower was reasonable and they were providing a mix of cash and property collateral for the rest of the purchase. Banks are not fond of providing 100% financing for purchases. That is, if the price is $900K then they would like to see some actual cash going in to the transaction.

This is particularly so when you want to borrow against the cash-flow of the business. I know that for many of you this doesn’t make sense but its all about lowering risks. On the face of it, plenty of businesses appear to have the available profits to pay the loan back if it was financed at 100%.

Thats just because you have been fooled into thinking that the profit presented is the actual cash-flow that will occur in your business.

Here is how I would structure the deal at $900K
purchase price and $270K cash-flow lend.

Ideally I would want to see approx. $200K cash going in to the deal.

The rest of the purchase might be covered by property equity and some vendor finance. So, here is one example:

Purchase price $900,000

Less $200,000 cash

Less $270,000 cash flow loan

Net $430,000

Say, $330,000 covered by equity in property and $100,000 vendor finance.

This mix of financing for the total purchase achieves a number of things.

The buyer (you) is putting in cash to the purchase to reduce the debt on the business.

You are also putting in a property and risking more of your assets. (This is known as ‘hurt money’ or ‘skin in the game’ by the way)

The bank is providing a total of $330K plus $270K = $600K to the transaction which is 67% of the total price. In fact on reflection you might need a little more cash or vendor finance as banks don’t usually like to have more than around 60% of the total transaction on their books. It will really depend on things like your experience, your overall net worth and the business strength itself.

The vendor in this case is financing $100,000. You might think vendors won’t do this, but they will. Especially if it means selling their business to a person that has achieved 89% of the funds necessary to make it happen. Remember that you are putting together almost $1M here. Not too many people can do that. This is not like buying a house where you have to come up with 10% deposit to get in.

So, this is the basic structure. Of course I would have to work out whether the business could afford this break up and this is dependent upon the loan terms and payments etc.


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