RAISING FUNDS TO BUY A BUSINESS (PART 1: DEBT FINANCING)
Buying a small business can be a life-changing investment. Everyone has different goals when they set out: some people are looking to escape the 9-to-5 “rat race” and work for themselves, and are looking for a business that will provide a secure income with rewards based on their own work. Others are looking for a business that they can build into an asset that operates without them. Some investors are looking for a larger business with more scale.
The type of business you are looking to invest in, and the size of the investment, will determine the financing options available, but all of the options can be categorised fairly simply. At the most basic level the funds for the business can only come from two places: (1) your own funds, or (2) someone else’s. The latter will be the basis of this 2-part blog post.
All of the options for raising external funds for a business purchase can in turn be categorised into either:
• Debt financing
• Equity financing
We would be remiss not to mention “family and friends” as a source of financing: after all, they may be among the most supportive financiers, providing either debt or equity financing (or both). But for the purposes of this post we will assume they have already been considered, and we will move on to other options.
Debt Financing
The financing options that people usually think of first in relation to small business investment all fall under the category of debt – in other words, borrowing the money. Debt financing allows the entrepreneur to invest money now and pay it back later, hopefully making a profit in the meantime which is greater than the cost of the debt (the interest). It allows a greater investment than would have been possible without the loan, and therefore a greater potential return for the entrepreneur. Borrowing money to leverage a higher return on investment is such a routinely recommended strategy that the phrase “other people’s money” (shortened to OPM) has become part of the business lexicon.
Loans generally take two forms:
Secured loans (where assets are used to give assurance that the loan will be repaid)
Unsecured loans (where the lender has no claim against any assets)
Unsecured loans are riskier for the lender of course, so they are given a higher interest rate. Usually the lender will insist that they are paid back over a shorter length of time also – these two factors together mean that the loan repayments will be much higher than for a secured loan over a longer time period. But if the entrepreneur doesn’t have any assets to borrow against (or doesn’t want to secure the loan using these assets), then unsecured loans can be useful.
There are a number of sources of unsecured loans. Depending on the size of the investment, unsecured loans would usually not be sufficient to fund a business purchase on their own, but if the entrepreneur has some funds available and only needs a smaller amount (eg: to fund working capital), unsecured loan sources can be valuable.
Secured loans are secured against assets – in other words, the lender can take ownership of those assets if the borrower defaults on the loan. But due to the lower risk to the lender, the terms are able to be more attractive for the borrower in terms of lower interest rates and longer payback periods.
Sources of Debt Finance
BUSINESS LOANS FROM RETAIL BANKS
The major retail banks all have active business lending facilities, and most will lend substantial amounts on an unsecured basis. Industry sources tell us that the standard limits for unsecured business lending for each of the following banks are as follows:
Lloyds £20,000
Barclays £25,000
HSBC £30,000
Natwest £35,000
But these limits are not fixed, and will be negotiated on an individual basis. Lenders are often willing to lend nearer their maximum level for franchises, especially those where the franchisor has operated for a long time in the UK and where there is a proven track record of franchisee success. They will only lend over the term of initial franchise agreement though. (It can be argued that buying a franchise is not really the same as buying a business, unless it is a franchise resale – buying a new franchise is actually more like starting a business – but this is a topic for another post).
Banks are willing to lend far greater amounts on a secured basis of course. As with unsecured loans, they are negotiated on a case-by-case basis and much depends on the business plan. But the loan amounts can be much higher, only limited by the security offered and the perceived risk to the bank. When buying a business that has a lot of fixed assets (like machinery or vehicles), the lender will use these assets as security against the loan. Where the business has freehold assets, the loan may be in the form of a commercial mortgage instead.
In some cases the lender will require additional security from the directors of the company that is buying the business, such as mortgages against their own homes. This security adds a lot of personal risk for the borrower and is not something we would recommend if it can be avoided.
The government’s Enterprise Finance Guarantee Scheme is designed to encourage banks to be more willing to lend to businesses, by guaranteeing 75% of the loan. The scheme applies to loans of between £1,000 and £1.2m, with terms of up to 10 years. Individuals are not eligible to receive EFG-backed loans, but companies are, and these loans can be used to acquire businesses under certain circumstances. If the purchase of the shares in the target company will provide a business benefit to the acquiring company (the deal must “add value”) then the loan will be eligible. The existence of the EFG scheme does not guarantee that a bank will approve the loan of course – the final decision is still up to the lender. But the scheme does reduce the lender’s risk, and can help to secure funding that would not otherwise have been possible.
In addition to traditional loans, banks offer other structures such as revolving lines of credit. These tend to be unsecured and as such usually have lower lending limits. They are useful for working capital but would not be used to finance the purchase of a business.
PERSONAL LOANS FROM RETAIL BANKS
An often overlooked form of unsecured lending is the personal loan. Banks frequently have personal loan facilities where the purpose of the loan does not have to be stated. Instead of spending the money on personal expenses or blowing it on a holiday, the money can legitimately be invested into a business instead. Again the loan limits tend to be smaller, loan terms shorter and interest rates higher as per most unsecured lending, but this funding can be useful as a top-up to other funding sources if required. We would advise against using relatively short-term and high-interest options of course, unless lower-interest options have been exhausted.
PERSONAL CREDIT CARDS
Along the same lines as personal loans, but with even higher interest rates, credit cards are another possible funding option. Countless stories have been told of scrappy entrepreneurs financing a business using their personal credit cards. However, with notoriously high interest rates, this is a risky strategy.
EQUITY RELEASE
Not to be confused with equity finance, “equity release” is a more attractive term for using your own home as security against a loan. There are many lenders who specialise in this kind of loan, and the major banks also offer this service. By taking out a mortgage against their own home (thus “releasing equity”), people can borrow significant sums and use this for almost any purpose they like, including buying a business. The interest rates offered are usually quite favourable since the loan is secured against property. However, this puts the borrower at significant risk, since their own home is at risk if the business should fail.
As stated above, we don’t advise entrepreneurs to use their own homes as security unless they have to – but the reality is that this is necessary in many cases because other funding sources are simply not accessible or won’t provide sufficient funds for the purchase, due to the individual circumstances of the borrower and the target business. If the entrepreneur is releasing an amount of equity that, in the worst case, they are comfortable with paying back via other means (by returning to employment, or selling another investment to pay back the loan), then equity release can be a useful way of raising a large sum for a business purchase, at a relatively low interest rate.
ALTERNATIVE LENDERS
Newer lenders have entered the marketplace in recent years offering both secured (up to £5m) and unsecured (up to £500,000) loans to existing businesses. They claim to make decisions more quickly than the banks, and use lending criteria that are not as restrictive (allowing younger businesses and those with lower credit ratings to access loans). However, they tend to be focused on providing growth financing for existing businesses, rather funds for the actual purchase of a business.
The government-run British Business Bank has a list of platforms it recommends for finding alternative business finance – at the time of writing there are three (Business Finance Compared, Funding Options and Funding Xchange). These platforms are not lenders in their own right – they are platforms for finding lenders. The platforms will attempt to match you to either secured or unsecured loans, depending on your circumstances and requirements.
Some of the lenders on these platforms will be peer-to-peer lenders such as Funding Circle, which allow small investors to contribute to the lending pot and receive a portion of the returns on the loans. The result for entrepreneurs is another source of potential funds, with more aggressive lending terms than the banks.
Although the main focus for most of these lenders is business growth rather than purchase, many of them do offer acquisition finance. This is primarily for businesses acquiring other businesses: if you are already running a company and looking to acquire another, these lenders will consider funding the acquisition. But for entrepreneurs looking to acquire their first business, peer-to-peer lenders generally are not suitable.
VENDOR FINANCE
A very important and useful funding option in the purchase of an existing business is for the seller of the business to agree to receive part of the payment for the business at a later date (or over a payment schedule). In this case the vendor is effectively lending the buyer some of the funds for the purchase. It is not uncommon for half or more of the purchase price to be financed in this way – especially for larger private businesses. In some cases the seller appreciates that it is the only way to get the deal done. The seller will be paid interest, just like any other loan, and depending on the agreed contract terms will sometimes have security over the assets. Also, since this payment method is not as attractive to the seller as an “all cash” offer (or an offer that is financed by some other lender, so that the seller receives cash), this may be reflected in the agreed price and deal terms.
Vendor finance is not to be confused with an earn-out, which is where the sale price is determined partly by the performance of the business over time. In this case a schedule of payments is agreed based on the achievement of pre-agreed milestones (such as gross revenue). If these are not met, the payment is less. An earn-out reduces the risk for the buyer, since at least part of the purchase price will be based on future earnings. It is obviously inferior for the seller, since it not only delays the payment (and is therefore technically a type of vendor finance), it has the potential to reduce the total payment. But it is very useful for the buyer. As long as the deal price and terms do not outweigh its benefit (with the seller demanding a higher sale price to compensate for the delay and risk), it can be a very useful form of financing.
Summary
Entrepreneurs looking to purchase a business do not have to fund the entire purchase themselves: extensive infrastructure exists to provide business loans of all types, both secured and unsecured. Debt financing has its disadvantages though, as we will see in our next post, where we will look at the other main source of deal finance (equity investment) and the way deals are structured using a combination of debt and equity financing.