Business acquisitions are a popular strategy for business growth and can help established entities expand into new markets and increase their profits. The key to a successful business acquisition is proper planning, including making sure you have secured the financing you need.
At CMP, our Utah CPA firm has assisted many of our business clients in making acquisitions. That includes helping them evaluate their financing options and obtain the money they need for the acquisition to go as smoothly as possible. We’ve created this guide to help you understand how to finance a business acquisition.
Acquisition Financing Explained
Acquisition financing is a type of lending that provides established businesses with the funds they need to acquire a business asset, which may include anything from the rights to a product or patent to an entire company.
Acquisition loans may be provided by banks, credit unions, private lenders, or even online lenders. It is common for lenders to use the asset being acquired as collateral for the acquisition loan, but there are some exceptions to that rule.
In most cases, acquisition loans are available only to established businesses with enough revenue to justify the loan.
How Acquisition Financing Works
Acquisition financing works like most other types of business lending with a few differences.
Acquisition Financing Requirements
Here are the things that business lenders will need to provide you with acquisition financing:
- Business and personal credit scores align with their requirements (for SBA loans, you’ll need a minimum FICO score of 640.): Most lenders will check personal credit for anybody who owns 20% or more of your company.
- Revenue: A good rule of thumb is that you’ll need a debt service coverage ratio of 1.25 or higher. You can calculate your DSCR by taking your revenue and dividing it by your total debt service.
- Down payment: You’ll need a down payment of at least 15%, and some lenders may require 20% to 30%.
You’ll need to provide them with business reports and other supporting documentation when you complete your application.
Acquisition Financing Application and Underwriting Process
The application process for acquisition financing isn’t complicated, but it requires attention to detail. In addition to completing the lender’s application, which may be done online in most cases, you’ll need to provide information about your business as follows:
- Your most recent three years of business and personal tax returns.
- Two to three years' worth of personal and business bank statements.
- Financial documentation for your business for the last three years, including your balance sheet, cash flow statement, profit and loss statement, and similar information for the business to be acquired.
- A detailed business plan.
- An estimate of your current debt service coverage ratio.
- Post-acquisition sales projections.
We suggest pulling your personal and business credit reports and reviewing them before you apply for an acquisition loan. It’s best to correct any errors before your lender sees the reports.
The underwriting process may take time as the lender reviews your submitted documentation. They may come back to you with questions; it’s important to answer as quickly and thoroughly as possible to avoid delays.
Different Ways to Finance a Business Acquisition
There are several ways to finance a business acquisition and not all require going to a bank.
The Small Business Administration provides business loans, including acquisition loans, to small businesses that meet their requirements. SBA loans are guaranteed by the federal government. Hence, they are sometimes easier to obtain than traditional loans.
Banks of all sizes engage in business lending. Banks often have the strictest requirements for acquisition financing but if you can qualify, you can typically get advantageous rates that you might not find elsewhere.
Debt Security/Issuing Bonds
A debt security is a form of lending that involves one party issuing a bond to another. In an acquisition, the bonds would be issued between the buyer and investors. The buyer must pay interest to the investors in return for their investment.
Online Business Loan
Online business loans are a good option, particularly for businesses that may not meet the requirements for borrowing from a bank or credit union. They typically have less-stringent requirements than traditional lenders, but you should expect to pay higher-than-average interest rates.
A leveraged buyout is a process of acquiring a controlling share in a company’s assets using outside money, often without the consent of the owners of the company being acquired. It is generally reviewed as an unsavory business practice. Bonds issued in a leveraged buyout typically have a 90% debt/10% equity asset ratio, which categorizes them as junk bonds.
Seller Financing/Owner Financing
It’s not the most common option, but if you’re negotiating with a seller who is eager to complete a sale, you may be able to obtain seller financing. Instead of borrowing money from a lender or getting an influx of cash from an investor, the seller agrees to finance the sale by putting the buyer on an installment plan.
In a situation where the company being acquired has substantial debt and is in financial trouble as a result, you may be able to acquire it by simply agreeing to assume their debt and make debt payments after you take ownership of the company. This type of acquisition financing is rare but can be effective under the right circumstances.
Crowdfunding is not a typical method of business acquisition financing, but it is an option for companies who want to give their customers a sense of ownership in the acquisition and the growth of the company. Crowdfunding sites such as GoFundMe make it relatively easy to create a campaign, which you would then need to promote to attract investors.
Person-to-person lending, or P2P lending, is a type of private lending that allows business owners to bypass the usual application and underwriting process to obtain funds for an acquisition. A private lender may look at many of the same things that a bank or credit union would, but they might also be willing to lend at a lower-than-usual rate if they’re interested in your business.
Venture capitalists are investors who provide working capital to companies when they see an opportunity to earn a profit based on their investment. Instead of interest, venture capitalists may want a percentage of your company, giving them an ownership stake and a share of the profits. To attract a venture capitalist, you’ll need accurate business reports and projections.
Advantages of Buying an Existing Business
Here are the major advantages of buying an existing business with business acquisition financing:
- Speed: Business acquisition is one of the quickest ways to achieve business growth. Companies can acquire skilled workers, core competencies, access to an expanded audience or market, and brand or product recognition in a single transaction.
- Meet or exceed stakeholder expectations: Stakeholders in your existing company may have been promised returns at a certain level. A business acquisition can make it easy to catch up if your profits haven’t been as high as expected and keep your stakeholders satisfied with their investment.
- Outdo your competitors: It can be difficult to keep up with or outdo your competitors when you’re hampered by slow growth. A smart business acquisition can help you gain a larger market share than your competitors, acquire new assets and competencies, and become the business of choice in your industry.
- Reduced entry barriers: Instead of spending months or even years trying to get a toehold in a new market, business acquisition can eliminate barriers that might have been standing in your way and make it easy to expand your market reach.
- Access to skilled workers: Small companies may have difficulty competing with large businesses for the best and most skilled workers. An acquisition can increase your visibility, making your company a desirable workplace.
- Access to capital: When you acquire an existing business, you increase your business assets. A larger net worth can make it easier for you to get additional financing in the future, including the funds you’ll need to acquire additional businesses.
These benefits make it clear why business acquisition is a popular growth strategy.
Disadvantages of Buying an Existing Business
Here are some of the most significant disadvantages of buying an existing business:
- Corporate culture clashes: When you acquire a new company and merge, there are likely to be differences in corporate culture that can lead to challenging situations involving employees and processes.
- Unforeseen expenses: Even a carefully planned acquisition may come with expenses that you couldn’t have foreseen that can put a financial strain on your company.
- Redundancy/duplication: There’s a risk that you’ll end up with employees who are duplicating one another’s efforts and as a result, there may be a need for restructuring or layoffs.
- Financial fallout: You may make the most accurate projections possible before your acquisition, but there’s still a chance that you may fall short of your projections. When that happens, there’s a risk that you’ll run into problems with your board or with investors.
- Interrupted operations: When too much of a company’s focus is on an acquisition and the subsequent challenges, operations at the original company may suffer. The result may be a loss of customers and a loss of revenue.
Each of these disadvantages may be managed to some extent, but you should be prepared for the unexpected if you decide to pursue business growth through acquisition.
The Role of Accountants in Business Acquisition Financing
Accountants play an important role in business acquisition financing. While some small business owners may have financial knowledge and experience, many do not. Partnering with an experienced accountant or CPA firm can help you navigate your business acquisition and avoid common pitfalls.
First, your accountant can help you interpret the financial reports and disclosures from the company you’re acquiring. They’ll have the training to recognize shady accounting practices and other issues and point them out to you during the due diligence process. It’s far better to learn about problems before the acquisition than after the purchase is complete.
A CPA can help you arrive at an accurate business valuation for the company you want to buy, providing peace of mind that you aren’t overpaying. Your accountant can also help you review your budget, determine whether the acquisition makes financial sense, and get your financial “house” in order before you apply for business acquisition financing.
Proper preparation will increase your chances of receiving the financing you need and help to streamline the underwriting process so that you can get your funds as soon as possible.
Finally, your accountant can advise on financial matters related to a merger if you intend to merge operations and provide you with ongoing advice to help you achieve your financial goals.
Closing the Deal: Final Thoughts on Business Acquisition Funding
Business acquisition funding can help you get the money you need to pursue rapid business growth by buying an existing company. Regardless of which funding method you choose, partnering with an experienced accountant will ensure the process is smooth and financially sound.
Are you planning to buy an existing business to grow your company? CMP is here to help! Read about our business valuation service and schedule a free consultation today.