Most business acquisition lenders require that buyers of a business provide a down payment, often referred to as an equity injection. The equity injection requirements range from 5% to 30% of the total transaction value. The percentage varies by transaction based on the details of the opportunity. In this article, we discuss:
- Why do you need a down payment?
- How much does a business acquisition cost?
- Five equity injection sources
- Home equity and retirement funds
Why do you need a down payment?
Lenders require that buyers contribute funds to the transaction as a condition of getting a business acquisition loan. It is one of the most important loan requirements, though not the only one. Lenders ask for an equity injection for the following three reasons.
a) Protects lenders against valuation drops
The equity injection provides lenders with a financial cushion that protects them from drops in the business’s value. This cushion limits the potential loss to the lender if the business does not work out as intended.
b) Ensures the buyer is financially committed
Putting equity into a transaction shows the lender that the buyer is committed to the business. Buyers with equity in a transaction are less likely to walk away from the company during difficult times.
c) Covers valuation differences
Most lenders only finance up to 90% of the company’s appraised value. However, any price discrepancy between the seller, buyer, and lender that cannot be resolved through negotiation must be resolved by increasing the equity injection contribution.
2. How much money do you need to buy the business?
The equity injection represents the amount of available funds the buyers need to buy the company. It is based on the total transaction cost, which is different from the seller’s asking price. The total transaction cost is the sum of:
- Price of the business
- Capital expenditures (CapEx)
- Working capital
- Due diligence costs
- Additional costs
Most of these costs are self-explanatory. Capital expenditures refer to costs associated with improving or buying physical assets, such as new machinery. Working capital refers to additional funds needed to operate the business. The equity injection is based on a percentage of the total project cost.
3. Equity injection sources
This section discusses five sources that can be used to raise funds to cover the down payment for an acquisition loan.
a) Personal savings
Your first funding source is to use your (and your business partner’s) personal savings. This strategy works well when individuals have been saving money for a while, preparing for the time when they would purchase the business. This strategy requires patience, dedication, and the foresight to know that you eventually want to buy a business.
b) Stock accounts
The second tier of funding is liquidating your existing stock accounts and converting them into cash. This strategy can have negative tax implications or even losses if done incorrectly. You should not use this source of funds lightly. If you choose this option, we suggest that you also work with a competent financial planner.
c) Your existing business (if you have one)
If you already own a business, another tier of funding can come from your existing business. If your business has assets that can be leveraged, you can get loans against them and use those funds to acquire the new company. This method is more common in scenarios where one company is merging/acquiring another one in the same industry. These transactions often occur as a leveraged buyout.
Note that leveraging your existing business also has risks. You are tying your existing business to the fortunes of your newly acquired business. If things go wrong, you could lose both companies.
d) Business partners
Buyers can also partner with other individuals to pool their resources to come up with the equity injection. Working with partners always adds complexity to an acquisition. It’s best to partner with individuals who bring something more to the acquisition than just funds. This can include experience or contacts. Additionally, keep in mind that so-called “silent partners” can become very vocal once money is involved. Consider retaining an attorney to advise you on this matter.
e) Gifts from family
Buyers can also use monetary gifts from friends and family to cover the equity injection cost. There are special rules that apply to gifts, though, so gifts should be handled carefully. Usually, the giver and the recipient must sign an agreement stating that the funds are being gifted and do not need to be returned. The agreement should be verified by an attorney.
Lastly, the funds need to be seasoned for a period of time in the giver’s bank account. This will be verified by lenders by asking for bank statements.
4. Your home equity and retirement funds
If you own a home, you could get a home equity line of credit and use those funds as part of the loan’s down payment. Likewise, you could do the same if you have a substantial retirement account. Or you could even use both sources of funding. This high-risk strategy should be carefully considered with a financial planner.
While some individuals have used these two equity injection sources and done well, many have not. This strategy is considered extremely risky since individuals are putting their family home and retirement at risk. It’s best to consider less risky sources to raise your acquisition down payment funds.
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Note: This article is provided for information purposes only and is not intended as financial advice. If you need advice, seek a competent financial adviser.