When you’re buying a business, the size of your down payment matters because it has an impact on your finances for years to come.
While there’s no simple formula for calculating the “right” size of a down payment, Jade Hipson, senior account manager at the Business Development of Canada (BDC) says it’s important to show you have some skin in the game.
“A lot of parties are being asked to take a risk on you—lenders, investors, even the buyer,” Hipson said. “The best way to show your commitment to these parties is to have a significant down payment.”
She says a good rule of thumb is for the down payment to cover 20 per cent to 30 per cent of the purchase price. Even then, lenders will often take it into account that a seasoned entrepreneur is likely to have different financial means than someone who’s just getting started, so the percentage can vary.
Overall, lenders are looking for a meaningful commitment in some form.
Someone who has worked in a company for many years and now wants to buy the company or a part of it, for example, will sometimes be able to purchase the company with a smaller down payment. In this situation, the buyer could argue they are less risky than a pure outsider. This could sway a lender to lower their requirements for the shareholder investment.
If lenders do not want to proceed with a new shareholder who doesn’t have significant funds to invest, one solution can be for the buyer to purchase the company over time. In these situations, the vendor will slowly sell off shares to the buyer and gradually exit the business.
Where does the rest of the money come from?
If you’re putting down up to 30 per cent of the purchase price, the remaining funds can come from a variety of sources.
A bank loan
Also called “senior debt,” this is a common way to cover a portion of the purchase price. This kind of loan usually has a set repayment schedule and relatively low interest rate compared to other options. The terms and conditions will depend on a variety of factors, including the size of your down payment, available collateral and expected business performance.
A low interest rate often comes with strict repayment terms that you can only fulfil if your business performs well right out of the gate, but since that often doesn’t happen, adding in flexibility is important.
Also known as “junior debt” or “subordinate debt,” this is a more flexible type of loan that can be structured in many ways—and sometimes even treated as equity, effectively increasing the size of your down payment.
This type of debt offers repayment terms adapted to a company’s cash flows, and targets a return on investment that will be more expensive than senior debt but will have flexibility in how that return is achieved (i.e. a mix of a lower coupon interest rate plus a variable return, such as a bonus or a portion of royalties).
Note that mezzanine loans rank below secured debt in repayment priority in case of default.
Also called “vendor financing,” this is an attractive option when you want to add flexibility to your financial structure. In this case, the person selling the business takes a portion of the price upfront and agrees to be paid the balance at a later date, often after much or all your senior debt is paid off.
That balance is usually secured through a lien on the property and assets of the company. If the buyer defaults on their payment obligations, the seller can step back in and take over the business, in some cases.
Often, seller and bank financing are combined. In this case, the seller’s lien is subordinate to the bank’s.
Another type of seller financing involves conditional payments, such as stock options or additional payments (earn-outs), if specified performance objectives are achieved.
These provisions help keep the seller tied to the company’s future success, which can be useful to ride out the usual surprises that arise during the early transition years.
- WI Staff with Business Development Bank of Canada.