Most people consider leveraged buyouts to be solutions that can only be used to acquire larger businesses. However, nothing about a leveraged buyout is specific to larger business. The concept can be used to acquire smaller businesses.
There is a catch, though. Just because the concept can be used by smaller businesses, it does not mean that smaller transactions have access to the same funding options that larger deals have. As a matter of fact – they don’t. Your available financing options are limited.
Small opportunities don’t have access to private equity funders because they prefer larger deals (there are exceptions). They also don’t have access to mezzanine financing or have the ability to issue bonds. Actually, financing a small leveraged buyout is similar to financing a management buyout. To accomplish the deal, you must use alternative financing.
Why would small businesses use a leveraged buyout?
From a buyer’s perspective, there is one main reason to use a leveraged buyout: well-executed buyouts can provide the opportunity for an excellent return on equity. If the deal is well structured, the business should generate enough cash flow to cover all regular business expenses in addition to the debt service from the buyout.
It’s the age-old concept of using leverage. Use a small amount of equity and borrow the rest. If the deal works out as planned, you stand to make great returns.
The seller’s perspective is a little different. A leveraged buyout provides a vehicle to sell the business. The hard truth is that finding a buyer for a small business can be difficult and time consuming. In some cases, you may not have many options and will have to be flexible in order to accommodate a potential buyer. Obviously, finding a buyer is even more complicated if the business is in distress and trying to execute a turnaround.
Purchase financing vs. operational financing
Most small business leveraged buyouts are funded using two categories of financing. The first category is the funding used to acquire the business. This funding gives the buyer “ownership” and the ability to operate the business.
The second category of funding is operational financing. This type of financing provides the working capital needed to execute the business plan and grow the business. Operational funding is often a critical piece of a successful buyout.
Financing the business purchase
Unfortunately, there are not a lot of sources to help buyers purchase the business. Most lenders and private equity funds prefer to work with larger deals.
Getting this part of the deal funded is the major hurdle the buyer must clear in order to make the purchase. Generally, there are four ways to finance the purchase of small businesses:
1. Seller financing (deferred consideration): One of the most important types of funding you can get is seller financing. Given that sellers have a vested interest in making the sale, you may be able to convince them to extend a loan that is amortized over a number of years. Getting seller financing also provides the buyer with some comfort, as it implies that the seller expects the business to have enough money in the coming years to satisfy the debt.
2. Buyer’s own funds: The buyer needs to contribute a portion of the purchase price from their own funds to handle the equity component. As a result, they may need to tap into their savings, sell investments, access retirement funds, or take a home equity loan on their house. It’s not unusual for buyers to use all or most of their assets to make the business purchase.
3. Assumption of debt: Another way to pay for part (or all) of the business is to assume existing loans. In some extreme turnaround cases, the only payment that buyers make is the assumption of business debt. The advantage to the seller in this case is that they can sell their distressed business without incurring personal liabilities due to prior loan guarantees.
4. Equipment financing: In some cases you may be able to finance part of the purchase price by financing the company’s existing equipment. This method can work if the company owns the equipment free and clear – and if the equipment has equity that can be financed.
5. Bank loans: In principle, buyers can get a business loan to purchase a business, and the SBA supports that. The reality is that getting a loan to purchase a business is difficult due to the qualification requirements. Getting a loan for a leveraged buyout of a small business may be next to impossible because the objective of a leveraged buyout is to put little equity in the deal in order to maximize the return on equity. Banks and SBA lenders, on the other hand, want buyers to maximize their equity investment before they provide a loan.
Financing business operations
In most cases, the buyer also needs financing to help run the business after the purchase. The objective of this type of financing is to provide funds and working capital to run the business. This type of funding puts you in a better position to execute the business plan and grow. Options for this type of financing include:
1. Business loans and lines of credit: One of the best products to help finance operations is a commercial line of credit. These lines give you the most flexibility at the best price. They are also very difficult to get – especially for small businesses whose assets are already leveraged. Lines of credit require substantial collateral and are also subject to strict lending covenants. Lastly, they are not an option for business owners with bad or “less-than-ideal” credit.
2. Factoring: Factoring is a financing option for small businesses that sell to commercial or government clients. Businesses must often sell their products/services on net-30 to net-60 terms. As such, they must wait up to eight weeks to get paid. Few companies can afford to wait that long for payment. Invoice factoring enables businesses to finance their accounts receivable. This option provides them with funds to pay suppliers, make payroll, and cover other business expenses.
3. Purchase order financing: Purchase order (PO) financing helps companies that re-sell third-party goods. Alternatively, it can be used to finance companies that outsource their manufacturing. Purchase order financing helps cover supplier expenses, thereby allowing the business to take on larger purchase orders. Note that this solution cannot be used by companies that do their own in-house manufacturing.
4. Asset based financing: Asset based financing is an umbrella solution that allows companies to finance multiple asset types. The line allows companies to finance receivables, equipment, inventory, and, in some cases, real estate. Asset based loans are considered intermediate products for companies that have outgrown factoring/PO financing but can’t qualify for a line of credit yet.
5. Vendor credit: One last source of financing that should not be overlooked is your own vendors. Vendors may be more willing to extend terms to your business than they were to the prior owner. Negotiating better payment terms, such as going from net-30 to net-45, or even net-60, can dramatically improve your cash flow. Learn how to get and increase your supplier credit.
One obvious financing risk is that the buyer can over-leverage the whole transaction. This scenario leaves the business unprepared to handle unexpected issues – which are likely to happen. This situation can create financial problems from the start, which are very hard to fix.
Another risk related to over-leveraging is the use of operational financing to cover part of the initial purchase cost. For example, a company could factor all outstanding receivables at purchase time and then uses those funds to pay the seller. This approach leaves the company with minimal working capital, since the majority of invoice payments for the next 30 to 60 days have already been used to pay the seller. You may then be forced to delay supplier payments or payroll. In many cases it puts the company into a financial tailspin from which it never recovers.
Need to finance a leveraged buyout?
The first step to work with us is to submit this form. Once we review it, one of our associates will contact you to discuss the specific details of your acquisition.