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Criteria for Being a Credible Candidate to Purchase a Business

A good lens through which to evaluate the credibility of a potential business purchaser is that of the commercial lender that would finance such a purchase.

There are three main areas of evaluation used by many lenders:

  1. Management and Governance
  2. Cash Flow/Profitability
  3. Security


Management and Governance

Strong business management is often the most heavily weighted criteria. Regardless of the quality of the assets/business being purchased, or the previous success track of the business, good management is required to ensure the business continues generating cash flow to repay the loan.

Examples of criteria for this area include:

  • Past history of running a profitable business.
    • Financing a first-time business owner’s proving ground is a highly risky venture, especially when the business owner has a key role in business development. It will be important for a borrower to evidence strong leadership skills, willingness to invest the time and energy required, the ability to build teams and gather resources, and to achieve targets.
  • Key employee retention
    • Preserving key employees through a business transition can sometime prove challenging. The greater the reliance upon key employees, the greater the risk. Uncertainty about their future with the business will magnify the risk.
  • Expertise
    • Lenders will consider the resumes of the purchaser and key employees in the business. They will want to see good evidence of knowledge and expertise that aligns with the business’ specific offering – product, service, industry, organizational structure, financial management.
  • Personal financial history
    • How the borrower has managed his/her personal financial affairs will weigh heavily in the evaluation process.
  • Business plan
    • Lender’s cannot assume that past performance will continue, especially with a new owner. A formal business plan detailing how the business will continue to succeed will be required.

Cash Flow and Profitability

The business must have a track record of producing the cash flow necessary to not only service the debt repayment but also to provide for the operational and growth needs of the business and income/returns for the owner.

Security

Lenders will look to both the business and the borrower to provide the underlying security to support the loan. Should the borrower be unable to meet loan repayment obligations from cash flow, other assets will need to be liquidated to resolve the remaining loan balance.

  • Lenders expect borrowers to provide a certain amount of their own capital, reducing the portion of the purchase price to be financed and also to ensure the owner has some “skin in the game”. They will not finance 100% of the purchase price and will be wary of purchasers who make up the difference by borrowing elsewhere.
  • Lenders will often consider “vendor take-backs” as equity, especially in the case of inter-family transactions. However, institutional lenders will require significant covenants and a creditor position well ahead of the vendor so the vendor may have to wait years to receive p ayment.

Other Things to Consider Before Purchasing a Business

Before purchasing a business, one must consider the real impact on their lives and how well the ownership scenario being considered aligns with his/her personal goals and lifestyle preferences.

  • Are you an entrepreneur?
    • It takes a particular skill and personality to build a business and continue to champion its success.
    • You must have a higher appetite for risk. Ideally you would also have other more conservative investments to balance your total risk portfolio.
  • Are you willing to make the sacrifices necessary to remain successful?
    • Time, energy and resource commitment
    • Tying up financial resources for long periods of time
    • Additional stress
    • Greater complexity in work and financial life
  • Are you jeopardizing spousal/family harmony and quality life
    • Lack of spousal unitity around financial and business affairs can seriously damage the relationship, especially when results are negative.
    • You must understand why you want to make the investment. Do you really need more money? Will leveraging your time, talents and resources into the profits and accomplishments you hope this business offers truly result in a better life for you and your family?
  • What if you want out?
    • Many business owners have a significant portion of their wealth tied up in their business. Accessing this captial can be difficult, especially if it could have a negative impact on business sustainability.
    • Others may not see the same value in the business as you do so selling for the price you need may not be possible.
    • Ownership transitions are risky and purchase agreements very often require exiting owners to remain in the business for a number of years. Payment terms may even restrict payment to future profits.
  • Are you self-aware?
    • One must have a good understanding of his/her personal attributes and be able to evaluate effectively the likelihood that making this investment will result in both financial and emotional success.


Purchase Financing Example

Purchase price: $10 million

Purchase price consists of:

  • Real estate - $5 million
  • Machinery - $2 million
  • Goodwill - $3 million

The typical commercial lender will finance at rates something like this:

  • Real estate – up to 75%
  • Machinery – up to 100%
  • Goodwill – 0%

Repayment Terms

  • Secured loans back by assets such as real estate can have terms up to 20 years.
  • Unsecured loans may only have terms for as little as 3 or 4 years.

So the commercial lender may finance up to $5.75 million in this case leaving the purchaser to come up with the remaining $4.25 million.

  • The seller may offer a vedor take-back of $3 million to be paid over 3 to 5 years. We will use 5 years for this illustration.
  • The purchasor would provide the remaining $1.25 million from personal resources. If this remaining amount was financed in any way, the main commercial lender would require much greater security and impose more demanding covenants on the business’ financial performance and position.
  • Subordinate financing can be obtained at significantly higher rates – currently around 10% or higher depending on level of risk

To review a Business Purchase Financing Example, DOWNLOAD FULL PDF HERE

Family. Wealth. Harmony.®

Covenant Family Wealth Advisors' certified financial advisors and business succession planning experts help guide families through the technical and emotional aspects of managing wealth, estate planning and business succession. Our experienced financial management team uses a Christian perspective that is rarely found in traditional financial planning, and we work closely with you to develop a personal Holistic Stewardship Plan that encompasses financial planning, estate planning, family business transition and philanthropy.

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