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Developing a solid understanding of how business purchases are funded is essential for both business buyers and sellers. We encourage all business buyers and sellers to familiarize themselves with the most common forms of financing used for Main Street and Middle Market business transactions. The following can help you get started with your research, but we encourage you to confer with your Sunbelt business intermediary to obtain more details about current market conditions.
- Bank financing for Main Street businesses is typically in the form of SBA loans. SBA loans are originated by SBA participating lenders, which generally make the loan with the SBA effectively guaranteeing the lender that the lender will be repaid. Instead, loans are approved and originated by SBA participating lenders. The SBA, in turn, agrees to guarantee some percentage of the principal balance of the load (usually 50%-70%). SBA-backed loans are subject to specific underwriting guidelines regarding fees, interest rates, collateral, personal guarantees, amortization, covenants, and other forms of debt. To learn more about the SBA and its loan programs go to www.sba.gov [link to SBA homepage] or talk to your Sunbelt Broker. In specific circumstances, non-SBA bank loans may also be available for Main Street businesses but it is less common.
If you are contemplating a Middle Market transaction, the following paragraphs summarize a number of basic concepts and terms with which we recommend you become familiar. Your Sunbelt business intermediary, accountant, attorney and banker will be able to work with you to identify and evaluate your best bank financing options. Middle Market transactions typically include one or more of the following forms of bank financing.
- Asset Backed Lenders/Loans vs Cash Flow Lenders/Loans – An asset backed loan is any kind of loan that is secured by an asset, usually a tangible asset such as inventory, accounts receivable, machinery and equipment, etc. Cash flow loans are loans which are made against the future cash flow of the borrower. Cash flow borrowers are typically companies with minimal tangible assets; examples of these types of borrowers would be software companies, professional service businesses (such as law firms and medical practices), etc. If you are evaluating acquisition opportunities and plan to use bank financing, it is important to make an early determination as to whether you will be obtaining an asset backed loan or a cash flow loan. Most banks are asset backed lenders rather than cash flow lenders and, consequently, cash flow loans are typically more difficult to obtain.
- Senior and Subordinated Loans – Senior debt takes priority over other forms of debt in the event the borrower goes bankrupt or needs to be liquidated. Senior debt typically has a first lien or claim on specific assets. Subordinated debt, which is sometimes referred to as mezzanine financing, may also have a lien or claim on the borrowers’ assets, but the lien or claim would be subordinated to the claims of the senior debt holder’s claims. Because subordinated debt is less secure than senior debt, it carries a higher interest rate. Typically, the interest rate is an additional 3% to 6% for subordinated debt versus senior debt; however, the spread or difference can be higher or lower depending on the borrower’s circumstances. Despite the higher interest rate, many Middle Market business buyers use subordinated debt rather than diluting their equity ownership by bringing in equity partners.
- Interest Rates and Bank Fees – Interest rates on Middle Market bank loans are typically expressed as a function of either LIBOR or Prime Rate. LIBOR is an acronym for the London Inter Bank Offered Rate. The Prime Rate is the interest rate charged by US banks to their most creditworthy customers. Historically, LIBOR is lower than the Prime Rate, but the amount of the spread varies based upon credit market conditions. There are various reasons why a Middle Market borrower may want a LIBOR or Prime Rate based borrowing rate and you should discuss the relevant factors and options with your banker; that said, it is most likely that you will have a Prime Rate based loan. Whether you have a LIBOR or Prime Rate based loan, your interest rate will likely be variable and your repayment period will likely be less than five years. For example, your interest rate may be Prime, plus 100 basis points (bps – remember that 100 basis point equals 1%, so if Prime were 4% and your interest rate was Prime plus 100 basis points, your effective borrowing rate would be 5%). In addition to the interest payments on the loan balance, banks often charge fees to their borrowers. There is usually a loan origination fee, which includes the bank’s legal fees for preparing the loan documents and other costs. Depending upon the nature of the loan, bank fees can be significant, so you should make sure these are negotiated at the early stages of your discussions with the bank.
- Covenants – The legal documents used to document a bank loan typically include debt covenants. It is very important to carefully understand and negotiate your debt covenants as the bank will require you to comply with these covenants throughout the term of the loan. Failure to comply with the loan’s covenants may either (a) affect the interest rate being paid on the loan, or (b) give the bank the right to terminate the loan. While there are a myriad of loan covenants, common examples include: (a) the need to provide the bank with annual, audited financial statements and unaudited interim financial statements, (b) the maintenance of specified financial ratios during the term of the loan (common financial ratios that are considered include net working capital, EBITDA to debt service, tangible net worth to total debt, etc), (c) restrictions on the disbursements of funds to the owners of the business/borrower and (d) key man life insurance for the business owner. There are many, many other common covenants; don’t be surprised to see 20 to 30 debt covenants in a loan.
Your Sunbelt business intermediary and local Sunbelt Office Owner should be very familiar with the bank lenders and the current lending environment in your local marketplace.
A portion of the financing for a typical Main Street transaction commonly comes from the business seller. We refer to this form of financing as “seller held notes" or "seller paper”. The amount and terms of seller financing agreements vary significantly depending on the nature of the business being sold, the general availability of third party financing, the buyer’s cash down payment and various other factors. The willingness of a seller to provide some financing is also an important psychological factor for some buyers in that it can be interpreted by buyers as a demonstration of the seller's confidence in the future prospects of the business being sold. While the interest rate on "seller held notes" varies, we usually see rates of 6% to 10%, depending upon prevailing interest rates, and the expected repayment period.
In the Middle Market segment, sellers may provide some form of non contingent financing, but it is less common than in the Main Street segment. That said, Middle Market transactions often include an “earn-out” provision which effectively makes a portion of the business sales/purchase price contingent upon on the future performance of the business. Earn-out provisions are popular with buyers in that they help mitigate the business buyer's downside risk. They are especially common when there is a significant fluctuation in the business' historical financial performance and/or historical to projected financial performance. Your Sunbelt business intermediary and accountants can assist you in determining what if any "earn-out" components should be included in the purchase price/offer for a business.
Retirement Fund Financing
Many of the business buyers we work with elect to use their retirement funds (401K plans, IRAs, etc) to finance their business acquisitions. Benetrends, Inc and other innovative firms have developed methods whereby you may be able to fund your business purchase by using your retirement plan assets without incurring taxes, interest or penalties. There is a very specific process to be followed when using these funding mechanisms, so it is important to use a firm that specializes in this type of transaction. If you are interested in learning more about this financing opportunity, ask your Sunbelt business intermediary.
Other Forms Of Financing
In addition to the SBA loan program, the US federal government sponsors the USDA program. There are a number of USDA loan programs. If you are contemplating a transaction in a rural area, we encourage you to learn more about USDA loan programs. For more information, please refer to www.rurdev.gov.
If you are a Main Street business buyer, you should also investigate the following additional sources of financing:
- Home Equity Lines of Credit
- Equipment Leasing
- Credit Cards