Loans: A Route to Funding Acquisitions
Starting a business from scratch is often fraught with challenges. The biggest one is securing the funds to launch and sustain a new business. Most entrepreneurs possess amazing ideas, passion, and the desire to bring their dreams to market.
However, a new business needs cash flow injection and without the right support, most businesses fail before they have a chance to gain any traction.
What if there was a better way to become a business owner without the risk of early-stage failure due to inadequate funding? You can become a successful business owner by securing lines of credit to purchase a business. This guide will offer you insights into different types of loans and why considering this route is a viable option.
Defining a Business Loan
You have probably taken out a personal loan at some point in your life. This could have been to purchase a big item for your home, a new car or to go on a dream holiday. A business loan isn’t that different from regular borrowing, except that it is a type of borrowing for commercial entities or businesses (online business or brick and mortar, for example) rather than individuals.
Although there are many different types of business loans available on the market, they typically fall into two categories:
- Unsecured loan: this type of loan allows your business to borrow money without using business assets as collateral. The amounts available as an unsecured loan are usually much smaller than when you put up assets as security.
- Secured loan: when it comes to securing large debts, most lenders prefer a form of security in the form of business assets. This type of loan reduces the risk on the lender's part because if you are unable to service your debt, the lender can sell the secured asset to recover their money. The cost of borrowing is typically lower (low interest rates) and you will have access to larger amounts of cash if using business assets as security.
Now that you know a little more about the broad categories of loans available to businesses, let's discuss why buying an existing business may be a better idea than starting one from the ground up.
Buying an Existing Business or Starting One?
Becoming a business owner through acquiring an existing business is one of the most finance-friendly ways to get into business.
Starting a business with very little capital is very much possible, but the road to growth and profitability is often challenging. There is a better route to running a successful business; buying an established one.
One of the biggest advantages of finding a ready-to-go business is that it is already generating cash flow, it comes with an existing customer base, premises (depending on the type of business), inventory and a brand with a loyal following. You also have the advantage of exploring multiple listings for sale, depending on your criteria and needs.
Whether you are looking for a unique business proposition or to become part of an existing business model as a franchisee, you can also search for franchise opportunities in the marketplace.
If you are already a business owner and looking to expand through a merger, you can explore MergerVault for high-value businesses ready for acquisition.
The Importance of Valuation
Whether you’re buying a home, a new car or investing in a new business, due diligence is an essential part of the decision-making process.
You have important decisions to make when you are looking to become a business owner. Understanding what makes a business valuable is one way to ensure that you make sound financial decisions. Here are some of the critical factors to consider before you get a loan to buy a business:
- Assets - what physical equipment, supplies and products does the business own outright i.e., not leased or secured against debt. Any assets with outstanding financing need to become part of the sales contract.
- Customers - most companies have a CRM system for storing customer data and you should ensure you have access to this valuable data as part of the business sale. Access to a customer database is worth more than any products or assets that come with the business in many cases.
- Legal and financial - due diligence is incomplete without investigating the books with a fine comb. Reviewing certified financial, cash flow statements, balance sheets and tax returns is crucial. The incorporation status of the business plus any other contractual obligations such as customer guarantees, and binding contracts should also be analyzed so that you fully understand the risk you’re taking on.
- Inventory and services - how much inventory does the business have, and what is its value? Will the business still be able to deliver its services after the sale and will you be able to run the business without experienced staff?
We offer a useful guide on valuation, detailing other important variables you need to consider. Likewise, you can learn more about the financial specificities of the business you’re interested in by conducting an accurate valuation. This will help you determine its fair value and aid you in deciding what size loan you’ll need. You can do this using our ValueRight tool.
Considerations Before Assessing Your Funding Options
When applying for a business loan, financial institutions consider a variety of personal financial factors. Before you go as far as applying for a loan, you need to understand your personal financial position.
- Credit scoring is one of the tools banks and other organizations use to determine creditworthiness. If you intend to apply for debt to finance a business purchase, you will need a stellar credit history.
- Once you have ticked the credit score box, you will need to consider your debt-to-income ratio. Expressed as a percentage, the debt-to-income ratio measures your ability to service your debts and your ability to afford your monthly payments.
Below is a simple calculation to clearly illustrate this concept:
If you pay $3,000 a month for your mortgage and another $200 a month for an auto loan and $800 a month for the rest of your debts, your monthly debt payments are $4,000. ($3000 + $200 + $800 = $4,000.)
If your gross monthly income is $9,000, then your debt-to-income ratio is 44 per cent. ($4,000 is 44% of $9,000.)
If your debt-to-income ratio is too high, evidence shows that you may face difficulties paying back your loans. This inability to pay your debts makes you a risk to financial institutions and therefore reduces your chances of securing funding.
- Tax returns: when you’re applying for a business loan, lenders may consider your tax history. Lenders use tax returns to verify annual income which may determine your ability to repay the loan.
- While a business plan is an absolute essential when you are starting a new business, it is also something to consider when purchasing a profitable business as a going concern.
The business plan will allow you to come up with new ideas on how to increase profitability while addressing all potential risks. The due diligence will help navigate the potential risks of the whole venture but having a business plan to complement it can only be a good thing. Lenders will also use the revenue projections from the financials to determine the loan. You can find out more about writing a business plan here.
If you can negotiate a revolving credit for your business loan, then you can have a consistent source of finance to turn to when you need it.
Finally, you need to ensure that you bring your best negotiating strategies to the table before agreeing on the final terms of the loan. The bank will try to get the best terms and as many covenants (restrictions) as possible to ensure they minimize the risk to their capital.
Your duty, on the other hand, is to try and secure the best interest rate, repayment period and as few restrictions as possible. The bottom line is that understanding how to negotiate a term loan that works for you is crucial.
Funding Options Available to You
Business loans come in different forms and this section of the guide introduces the different types of funding sources for buying a business. Each of the sources come with pros and cons, so it will be your responsibility to weigh these up.
An unsecured loan allows an applicant to access funding for various business purposes without putting up security. If the business you own or want to acquire does not own many assets or you prefer not to offer any security, the unsecured loan option may be what you need.
The apparent benefits of an unsecured loan are that you can access a variety of funding options relatively quickly. Also, the upfront costs of acquiring this type of loan may be lower but you may have to pay over the odds in terms of interest rates.
Commercial mortgage or real estate loan
Suppose the business you are intent on purchasing owns commercial premises, a real estate loan or commercial mortgage would be an ideal way to finance the purchase. A commercial mortgage puts you in control and prevents the shock of rent increases on your business operations.
Commercial mortgage loan terms are much like residential terms because you have to pay the loan off in a set period of time. Your company must meet its monthly repayment obligations. Banks will offset the risk of providing the loan by requesting an initial deposit, typically 20-25%.
How much funding a bank can offer, and the repayment terms will depend on your company’s ability to repay the loan. Again, the valuation of the business you intend to purchase, and projected revenues will help considerably in determining the final terms.
Asset finance is a form of business lending that enables organizations to purchase capital assets without providing cash up front. This type of lending is for specific purposes such as buying manufacturing equipment or machinery to increase productivity. Asset financing can also be used to fund equipment leasing agreements as well as outright purchases.
Organizations can also release capital from assets they already own by using them as collateral against the loan. Asset finance lending is a specific function of the capital markets, and you will typically find companies that specialize in this type of business financing.
Asset-based lending is a type of asset-based finance that unlocks the value in a company’s assets by providing collateral for funding. Companies usually turn to this type of short-term lending to tide over cash flow problems. Organizations will use a line of credit to make sure they meet other pressing financial demands.
Assets that companies can use as security include their order book, physical assets such as property and equipment, or stock and debtors.
The advantages of turning to this type of financing include reduced upfront costs, quick cash flow boosts and you can keep hold of your equity.
In some cases, a single source of funding doesn’t provide adequate capital to buy a business. In such circumstances, you may need to tailor your needs and seek to combine multiple sources of funding to achieve your goal.
A typical example includes buying an existing business including inventory and fixing using one type of loan and a commercial mortgage for the building premises. Combination loans may take other forms but the essence is that they involve mixing different types of business loans to raise funding.
If you are looking for a versatile approach to business funding, then you should consider a combination loan.
Other Sources of Funding You Can Consider
Angel investing is another source of finance open to new businesses as well as a business owner looking to take on an existing business. Angel investing is perceived to be high risk (especially in the case of start-ups) and so the investors may demand as much as 20% of the equity of the business in return for providing the finance.
Angels will often receive equity or convertible debt (a loan convertible into equity later) in exchange for their capital.
There are various grants available to help you grow a business. Although it’s a suitable method for raising funds for a start-up, it may be difficult to find grants that will support the acquisition of an existing business.
Local, regional, and state governments provide grants to help small businesses grow and the beauty of a grant is that you don’t have to pay it back. Any business that has the potential to bring employment to local areas and to develop the local economy may be eligible for a grant.
Typically grants can only provide small amounts of total finance requirements and so you may have to consider combination loans to use alongside the grant. A common condition of grant awards is for the recipient to match the grant amount.
The application process for grants is usually lengthy, with many businesses vying for the same grants. You may need to work with specialist companies who can help ensure you put the best application forward and increase your chances of winning the grant.
Government-guaranteed lending scheme
State and National Government-guaranteed lending schemes support new and established businesses with funding. Most government-backed loans have favorable repayment terms while some have very low-interest rates as well.
The government will guarantee up to 80% of the loan to the lender while you remain liable for 100% of the debt.
Participating lenders in the scheme will determine how much they can offer your business based on a variety of criteria.
The loans available under this type of lending scheme includes:
- Term loans
- Invoice or receivables finance
- Asset finance
Venture capitalists (VCs)
Venture capital funding assists businesses with cash to grow and expand into new markets.
The potential for high returns attracts $100,000 investments into companies with huge growth potential because they sell unique products and services. Unlike angel investors who typically jump in at the startups initial phase, VCs prefer to invest in companies with a proven track record.
In addition to providing cash, venture capitalists may also bring operational or strategic expertise to the businesses they invest in. Some VCs go as far as getting involved in the daily operations of the businesses.
Friends and family
When you do not have any other loan options available to you, you can always turn to family and friends. However, before you jump right in and start pitching your idea, becoming indebted to family or friends poses some unique risks.
Being a responsible borrower from friends and family will help you protect these relationships throughout the term of the loan. Friends and family know you better than anyone, and they are likely to give you better terms on your borrowing too.
While friends and family will offer flexible terms and forgive some missed payments, you need to preserve relationships by adhering to the agreed terms. Always have the agreement in writing and ensure the loan is a loan and not a gift or investment.
Equity finance is a common product in the start-up financing world but can also apply when buying an existing business.
When you receive equity funding you sell a stake of your business to the investors. Depending on the size of the share you put up for sale, there is a risk of losing control of the business.
Equity investors also have a vested interest in the success of the business and may also bring essential skills, contacts, and resources to the business.
An advantage of this type of financing is that there is no fixed term for loan repayment, and interest is not due. As the value of the business grows the investor’s “stake” in the business also grows.
Equity finance is a long-term investment strategy and may not be ideal if you are looking for a more immediate solution to cash flow problems.
Using personal funds to buy a business is one of the first ideas many people arrive at. However, it is often the case that the business requires more capital than individuals have at hand. Also, unless you are a big believer in saving, most people have their cash tied up in other assets such as stocks.
Using your banker is also another option and you can arrange a bank overdraft to receive a cash advance so that you can use the money to buy a business.
Credit cards are another option if you have an excellent credit rating as well as a large enough credit balance. Overdrafts and credit cards are only suitable for short-term capital needs because the interest rates tend to be higher in comparison to other funding sources.
Achieving Your Dream of Buying a Business
While buying a business does have its advantages, you’ll need a considerable amount of money to pay for it. While you may have savings available, you’ll still need capital to fund extra costs, like fixtures, fittings, inventory, and a commercial lease (if applicable).
It’s important to be aware of the options available to you, but to also be conscious of their disadvantages and the risks you’ll take on if you pursue them.
Nonetheless, this is an exciting venture that we wish you every success on!
If you need more support, or you’d like to speak to someone from the team, you can contact us here.