Why Lenders Like Funding Business Acquisitions

Three words sum up Karin Mills' business philosophy: refurbish, recycle, reuse. "If I can spruce up a room or equipment, I've saved thousands for something else," says the Carrboro, North Carolina, restaurateur. "I don't know what I'd do if I had a slab of land and had to decide what kind of building to put there. But it would probably be square." That's because Mills and business partner Linda Bourne, 39, have encountered some unusual structures. When launching their first venture in 1998, Spotted Dog Restaurant & Bar, they had to contend with a V-shaped building with narrow walkways. Then they set their sights on a restaurant in a train car, which they adapted into an old-fashioned soda shop.

Both times, they made the most of unique opportunities absent major commercial funding. Growth was swift, particularly after adding catering to the business mix, but their facilities were ill-equipped to handle the increased output. "We were making ice cream, and we were in a train car," recalls Mills, 37.

Then came their big break: a thriving dessert cafe for sale in an eclectic Durham, North Carolina, neighborhood. Not only would it provide more elbowroom, but it was also an opportunity to expand their ice cream business. The cafe had its own line of Italian-style ice cream and sorbets, to which Mills and Bourne could add their "soy creams." With the extra space and equipment, they would be able to supply area stores and eateries.

For this transaction, the women needed more than a little help from family and friends, the main source of outside funding for their business collaboration up to that point. And despite their early successes, they had to work hard to get a bank onboard for such a major expansion. That they were buying an operating business with an established clientele undoubtedly helped, but bankers needed assurance. "We fielded questions about whether we were biting off more than we could chew," Mills recollects. "We knew it sounded ridiculous that adding another business would make it easier, but in the long run, we knew it would meet all these other needs." A local bank eventually agreed to provide funding for the acquisition in early 2003. Had the women wanted to build their own facility, though, the outcome may have been much different. "We probably wouldn't have gotten the loan," Mills admits. "But if I go back in a year, either to buy a business or to expand, they would look at me in a different light."

The truth is, Mills' credit prospects are probably better if she continues to buy rather than build. Lenders tend to view buyouts more favorably, because the acquired business has a credit history, existing assets and a customer base, while organic growth may take the entrepreneur into untested territory. Another advantage is the potential for seller financing, which often provides more favorable terms than otherwise available.

Although buying clearly has benefits- access to cash flow and existing operational infrastructure among them- often is a downside. Entrepreneurs frequently have to absorb employees and costly overhead, which can zap operating funds. Moreover, acquirers may have trouble getting traditional financing if creditors, who tend to appraise assets based on liquidation value, not replacement cost, believe the deal is inflated.

Before financing any growth, creditors want to know that the borrower has a bona fide growth opportunity and the requisite skills to capitalize on it. "If there is that mix, it says to the lender that all that's keeping [the entrepreneur] from being really successful is the lack of money," observes Mary Speight, an assistant regional director at the North Carolina Small Business and Technology Development Centerin Durham, North Carolina. "That's the clincher for most bankers."

Given the choice between internal expansion and a business purchase, however, lenders generally view the latter as inherently less risky. "I would say there's less risk in buying something that's viable with customers because [the entrepreneur] is absorbing someone else's customers, and there isn't a new competitor," says Emilia DiMenco, executive vice president of Harris Trust & Savings Bankin Chicago. DiMenco, however, is cautious when the purchase represents more than 25 percent of the buyer's overall operation. In large deals, the financial strength of the borrower is often a deciding factor. "A strong acquirer," she maintains, "can sustain greater operating and financial risk than a weak acquirer."

Entrepreneurs, on the other hand, often consider buyouts a cheaper alternative to investing in infrastructure of their own. That isn't necessarily the case, experts warn. "They may need to bring on additional assets," stresses Richard Cheney, associate state director of operations for the Connecticut Small Business Development Centerin Storrs, Connecticut. "They'll need an increase in permanent working capital." In fact, underestimating capital expenditures is one of the most common mistakes acquirers make. "The equipment might be fully depreciated, meaning that it's likely in the first few years they'll have to replace it," Cheney adds.

Mills experienced tighter cash flow after her recent purchase. "We weren't able to continue doing a few of the things the previous owner had done, like advertising," she says. Additionally, some planned upgrades, such as installing a new dishwasher, had to be accelerated after a health inspection. The sacrifices were worth it for the new owners, whose combined businesses now generate about $1 million in annual sales. "I do baking here for our other restaurants, and we do wedding cakes here for the catering business," says Mills. "It was really the plug we needed to give us enough space."

Before you buy a business, experts recommend you thoroughly analyze the company you're considering. Comparing it to industry peers will reveal how the company is performing beyond the seller's hype. If the assessment uncovers middling performance, you could use it to negotiate a lower price or to make the case for seller financing. Not only do sellers typically offer more lenient terms and a less rigorous credit review, but they often take only the business's assets as collateral, while conventional lenders may also require personal holdings.

Determining a company's worth isn't an exact science, so negotiations with traditional creditors may break down over purchase price. Conflict over the value of intangible assets like a business's location or client base can jeopardize financing. "The lender often says, 'There's no collateral behind [the intangible assets],'" says Cheney. "If you don't have enough collateral from the assets of the buyer, seller financing is often required." Most seller financing is only for about five years, but it may be amortized over a longer period, with a portion of the principal remaining at the end of the loan term; the buyer has to get outside financing to pay off the balance in a "balloon" payment. The initial payout, before an outside creditor is involved, can be steep. "There's more cash going out," says Cheney, "but they're paying less interest."

Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.