Developing a solid understanding of how business purchases are funded is essential for both business buyers and sellers. There are several was to fund a transaction, and funding it properly has an advantage to both buyer and seller. It is important for business buyers to familiarize themselves with the most common forms of financing used for small and larger middle-market transactions. There are four common methods of financing; bank financing, government-backed financing, vendor take-back financing and personal leveraged financing.
In Canada, bank financing is offered by the “Big Five” banks and the credit unions. As independent organizations, their lending policies vary according to their own parameters.
Small businesses are an important part of Canada’s economy, but they sometimes face unique challenges with financing. Both the Business Development Corp. (BDC) and the Canada Small Business Financing (CSBF) programs offer alternatives to conventional lending.
BDC operates as independent, non-profit organization that is owned by the federal government; and exists to stimulate small business development. All BDC loans are government-backed.
The Canada Small Business Financing Program is a federal initiative to help business owners with financing needs. Under the CSBF program, the government of Canada makes it easier for small businesses to get loans from financial institutions by sharing the risk with lenders. Up to a maximum of $500,000 is available for any one business, of which no more than $350,000 can be used for purchasing leasehold improvements or improving leased property and purchasing or improving new or used equipment. Financial institutions deliver the program.
Vendor take-back financing
A portion of the financing for a typical small business transaction commonly comes from the business seller. This form of financing is commonly referred to as “vendor take-back,” “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.
In the middle-market segment, sellers may provide some form of non-contingent financing, but it is less common than in the small business segment. That said, middle-market transactions often include an “earn-out” provision which effectively makes a portion of the business purchase price contingent upon 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.
If you are a small-business buyer, you should also be aware of additional sources of financing referred to as personal leverage funding. There are two main levels of funding, and additionally there is two forms lenders require to secure the financing.
Asset-backed vs. cash-flow 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 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. 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, cash0-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 per cent to 6 per cent for subordinated debt versus senior debt; however, the spread or difference can be higher or lower depending on the borrower’s circumstances. Many middle-market business buyers use subordinated debt rather than diluting their equity ownership by bringing in equity partners.
Another method of funding the operations of a business, is equipment leasing. Rather than sourcing a large capital outlay to buy equipment, leasing may be the better option. This form of funding has become widely used in gas and oil related industries because of the volatility of the global commodities.
Whether you intend to acquire a small or middle-market business, knowing what financing options available is critical to mitigate risk and maintain profitability.