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Financing a Business Acquisition in a Recession

It is essential to understand the many options for financing.
May 13, 2009
URL: http://www.entrepreneur.com/article/203664

In today's economy, securing financing to purchase a business has become a full time job, and there's no guarantee all the hard work will pay off in the end. Banks have all but disappeared from the process, leaving business buyers and sellers wondering how they can possibly get a deal done. This is in stark contrast to 2008, when loan origination fees were healthy and banks were vying for SBA-backed business loans. In fact, most of the banks our brokerage firm was dealing with in 2008 have completely abandoned these types of transactions. This leaves most business brokers, buyers and sellers competing for a shrinking number of financing options.

The government's attempt to boost bank lending to businesses is falling on deaf ears. We have seen cash levels on bank balance sheets triple over the last year, while lending has steadily declined. In addition, the SBA, which serves as a guarantor for many of these loans, has taken steps that have made this market even more erratic. The good news is that the stimulus bill included new SBA plans for temporary fee reductions; guarantees increased to 90 percent for certain types of loans, deferred payment loans micro loans and several other improvements. The bad news is that the SBA, acting outside of the stimulus bill, has enacted a significant change to business acquisition loans by placing caps on goodwill financing.

On March 1, 2009, the SBA enacted a change which limits the amount of goodwill in a business acquisition loan to 50 percent of the loan with a hard cap at $250,000. Goodwill is the portion of a business that is in excess of the physical assets and inventory. Given the shift in the economy from asset-based businesses to service-based businesses, the majority of small business transactions now originate from such goodwill financing. This is devastating news for small business owners and potential buyers, as it has effectively negated any of the positive intentions of the stimulus bill.

Lenders, as well as the business brokerage industry, have united behind this issue and lobbied SBA officials with little success. Hopefully, the SBA will realize this change is causing banks to shy away from business acquisition deals, choosing instead to deploy their resources toward asset-based lending.

Despite these hindrances, buying a business in this economy is still a real option for people who have lost their jobs. Many retiring baby boomers--a large percentage of small-business owners in the nation--are looking to sell and now could be a great time to buy if you are prepared to explore financing alternatives.

Before determining a financing solution you must understand the historical earnings and current trends of the business you wish to acquire. Calculating the true earning power of a business can be a difficult task. Most business owners maximize tax strategies to minimize reported earnings so they pay fewer taxes. Therefore, when a prospective buyer looks at the net income, they may not be seeing the whole story. Business sellers and their advisors will often "recast" the earnings to show the earning power of the business. This recast number is commonly referred to as seller's discretionary earnings.

Seller Financing
Because bank financing is complex, has high closing costs and is almost impossible to secure right now, seller financing is quite common in business acquisitions, and a must in today's economy. Seller financing can be as flexible as the buyer and seller need it to be and is only limited to what the buyer and seller can agree on. The seller, like a bank, will still be concerned with the buyer's net worth, credit history and experience in the industry. The seller is also likely to want a higher percentage in down payment from the buyer because they are at more risk than a bank. Most buyers like the idea of the seller financing since it simplifies the financing and keeps the seller vested in the business' future success.

There is no doubt that tough times are still ahead, and until the banks and SBA get back to the business of lending for business acquisitions, rather than deterring it, business sellers and buyers should know that there are alternatives. With the help of good advisors and creative thinking, buyers will find there are still plenty of excellent acquisition opportunities.