Of all the various financing requests, this is the one least understood. The reason for this is that there are so many people, including some bankers, that have little to no experience in this field.
The financing of a business purchase usually involves structuring a deal that can be accepted by all parties, whilst still being affordable. In many cases, the financing required is underpinned by ‘cash-flow’ lending. That is, advancing funds on the pretext that the bank has no other collateral (security) other than the cash-flow of the business itself.
If you are thinking of buying a business and want to borrow money to do so, you will be met with plenty of opposition as well as misinformation, even from those people that should know better.
Before we go into the details here is one rule of thumb.
Unless its a franchise, if the business purchase is under say $700,000,
then you will more than likely have to provide collateral for any amount you need to borrow.
Different types of businesses can be financed using the business itself as collateral.
Here are some for you to consider:
Franchises
Many franchises can be financed by the major banks using the business itself as collateral. Franchises purportedly represent a lower risk to banks because they are systemised, have processes and management plans and are overseen by the franchisor in terms of performance reporting. The franchisor is usually collecting a royalty or franchise fee from each franchisee and as such has an interest in supporting the business and helping the owners to turn the business around if it is suffering.
Franchises usually go through an approval process with some of the majors and once complete a percentage of the purchase prices is usually set as the amount the bank will lend you to buy one. For example, say they set that percentage at 60%, then you will have to contribute 40% of the purchase price plus costs and working capital in order to buy the business.
Manufacturing
When buying smaller manufacturing businesses (with profits less than $1M) you may struggle to find banks that will finance against the business itself. Usually, however, these types of businesses have some plant and equipment on the balance sheet and you can probably obtain some financing against the value of this machinery.
Management Rights
Management Rights businesses are very popular in areas where buildings made up of a number of apartments are rented out to either holiday makers or to permanent tenants. The purchase of the business has the RIGHT to manage the apartments as well as collect a commission for letting out these apartments. It’s really income derived by a real estate property management commission, combined with a salary paid for by the body corporate of the building. Sometimes the owner of the rights also has a real estate sales licence and can sell the apartments as well and thereby obtain more income. Apartments that are managed by the owners of the rights are considered to be in the ‘rental pool’ and its a multiple of the income derived from this rental pool plus the salary that you are paying for.
Multiples of this income are then added to the value of the residential unit that you have to buy as part of the transaction to enable you to live on site.
So, the income might be $100,000 x a multiple of 4 = $400,000 plus a $400,000 unit = a price of $800,000.
In general, banks will usually lend you about 65%-70% of the total $800,000 price. It might be structured as say 80% of the Unit and then 60% of the price of the ‘rights’ which equals $320K plus $240K totalling $560K or 70% of the overall price.
The multiple that is applied to the income amount is a function of return and risk. So, if you are paying 4 times the $100,000 then your pre-tax return for this purchase will be 25%.
On the following page, I’ll provide a few examples of how I have structured various business purchases using the business and its cash flow as the collateral for the loan.
On 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 cash flow. 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, the 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 into 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%.
That’s 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 into 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, would have to work out whether the business could afford this break up and this is dependent upon the loan terms and payments etc.