This article explains how to finance the acquisition of a machine shop. It helps you whether you are an individual buying your first business or are expanding your machine shop by acquiring competitors. We discuss the following topics:
- How to finance the acquisition
- What do lenders look for in a transaction?
- Should real estate be part of the purchase?
- Post-acquisition working capital
- Typical acquisition structure
How do you finance an acquisition?
Most small and medium-sized machine shop acquisitions have relatively simple financing structures. Buyers use one or more of the following four options.
1. Personal funds
The simplest way to finance the purchase of a machine shop is to buy it outright using your own funds. This method removes all the issues that come with getting financing. But it also requires that the buyer have considerable assets – and a lot of cash. As you can imagine, this situation applies to only a very few potential business buyers. Most buyers will need to use some form of external financing.
However, every buyer should expect to contribute some personal funds to the transaction. Most lenders require that buyers add an equity injection to the acquisition. The size of the equity injection varies but averages 10% of the acquisition price.
2. Seller financing
Seller financing is a common way to finance a part of an acquisition. The seller offers a loan that you pay off through an amortization schedule. Sellers are usually more flexible than banks and non-bank lenders.
When negotiated correctly, sellers can provide loans with very competitive terms. More importantly, this type of financing ties the seller to the performance of the business (up to a point). Consequently, the seller has an interest in your success.
3. SBA-backed financing
Most transactions under $5,000,000 are financed with the backing of the Small Business Administration (SBA). Keep in mind that the SBA is not a lender. Rather, the SBA provides guarantees to lenders, who then provide financing to business owners.
There are a number of lenders, both bank and non-bank, that offer SBA-backed loans. Though they share some underwriting requirements, each has its lending preferences. This is an important detail that few buyers take into account when they encounter problems. A rejection from one lender does not necessarily mean that another lender will also decline the opportunity. You must find the right lender for your transaction.
Learn more about “How to get a business loan.”
4. Conventional bank financing
Not every opportunity qualifies for SBA-backed financing. Some transactions are either too big or are in industries that the SBA does not support. In those instances, buyers can also approach conventional banks. Alternatively, they can also try non-bank lenders.
Keep in mind that business acquisition loans are not easy to get. Banks lend only to individuals and companies that have substantial assets and/or revenues.
What do lenders look for?
Try to understand the perspective of your lenders. Know what they look for in an opportunity – and what they avoid. This knowledge helps you understand where objections are likely to come from. It also helps you approach the transaction in a way that has the best chance of success.
1. Transaction size
Most finance companies and lenders focus on transactions in a specific size range. You can improve your chances of success if the size of your transaction falls within your lender’s core business. In our case, we specialize in acquisitions that range from $500,000 to $5,000,000. We can handle larger transactions in situations that fit our underwriting criteria.
Most lenders consider funding acquisitions of profitable machine shops only. Lenders want your acquisition to be able to pay for the ongoing financing costs out of its own cash flows. This point is important and there are seldom exceptions. Few lenders stray from this prerequisite.
3. Business collateral
Lenders like to finance businesses that have collateral. This is why finance companies like to work with machine shops. Machinery and equipment makes excellent collateral to back their financing. CNC equipment (e.g., mills, lathes, EDMs, etc.) is marketable, easy to appraise, and maintains its value well.
Lenders want the acquisition cost of the company that you are buying to be in line with market realities. They want the price you pay to be reasonable. They don’t want to risk lending against the purchase of an overvalued business. And, as a buyer, neither do you.
Most lenders use their own proprietary valuation formulas during the initial underwriting of the transaction. These formulas provide a “good-enough” estimate and allow the transaction to move through the process. You can find similar estimates in the Business Reference Guide or a similar publication. Here is an example from the guide’s section about pricing machine shops:
- 3 to 5 times EBIDTA
- 4.5 to 7 times EBIT
- 3 to 5 times SDE plus inventory
Once a transaction moves further along, lenders usually request a professional valuation of the machine shop. This valuation is also supplemented by appraisals of the machine shop’s assets, which are important collateral for the transaction. Valuations and appraisals are usually done by a professional with ample industry experience.
Note: some definitions:
- SDE – Seller’s Discretionary Earnings
- EBIT – Earnings Before Interest and Taxes
- EBITA – Earnings Before Interest, Taxes, and Amortization
5. Buyer industry experience
Lenders prefer to work with buyers who have direct experience managing a machine shop. This preference can create difficulties for aspiring business owners who don’t have management experience.
Buyers in this situation have one way around this problem. They can hire a manager from the existing business to stay on for a period of time. The manager must be retained with a contract for a specific period of time.
6. Buyer 10% equity injection
Lenders require that buyers contribute at least 10% of the price as part of the acquisition. Finance companies will not consider working with buyers that cannot inject equity into their own business. The equity injection can’t be borrowed and can’t come from the seller. Generally, these funds should be available in a checking account, investing account, etc. Learn more about “The cost of buying a business.”
The equity injection can be reduced to 5% if two conditions are met. The seller must provide seller financing and their loan must take a standstill for the life of the lender’s loan. In our experience, finding a seller willing to agree to a standstill is very difficult. For information, read “What is an equity injection?”
7. Buyer’s collateral
The equity injection mentioned in #6 is sufficient “collateral” for most transactions. However, most finance companies prefer to work with buyers who have additional collateral. However, most lenders try to be flexible about this requirement since buyers are usually investing a large part of their savings to the venture.
8. Buyer’s credit score
The buyer’s personal credit score plays a role in the initial review of the transaction. Most institutions require a minimum score of 650. Finance companies use credit scores to determine whether to handle a transaction or not. Asking for a personal credit score can cause confusion among buyers. They often question why their personal credit is relevant in a business transaction.
The lender’s logic is as follows. Businesses don’t manage themselves. Rather, they are operated by their buyers/owners. Although an imperfect measure, a credit score shows how a person manages their financial life, and, consequently, their business life.
Should you buy the real estate as well?
Buying the business and its associated real estate has advantages and disadvantages. There is no easy or simple answer to this question.
From a lender’s perspective, including the real estate in the transaction adds valuable collateral. In many cases, it can strengthen your case to get approval for the financing you need.
Some lenders even extend the amortization period of the entire loan if more than 51% of loan proceeds is used for the real estate portion of the transaction. This can increase the amortization period of the entire loan to 13, 17, or 25 years. This amortization period has some obvious benefits and implications.
Buying the real estate associated with the business also increases the acquisition price. Consequently, it also increases your debt load. More debt can have business and personal consequences for the buyer.
Ultimately, there are many considerations you need to take into account if you opt to also acquire the company’s real estate. Examine the details carefully with your advisers to determine if it makes sense in your case.
Will you need working capital also?
Running into cash flow problems after the transaction closes is not uncommon for business owners. Most buyers do substantial planning to get financing for the acquisition. However, they often neglect getting additional funds to help run the business post-acquisition.
This oversight creates a predicament. The new business owner determines they need additional financing after buying the business. However, all the business assets are already pledged to the lenders. There is no more collateral – a common problem in leveraged buyouts. To complicate matters, even if you get a new lender, your existing lenders are unlikely to subordinate a part of their position. This situation blocks any chances of getting subsequent financing in the short term.
We have a strategy to handle this problem that tends to work well. We layer a factoring line with the acquisition financing package. We do this at the time of the acquisition, which provides a single, end-to-end solution.
Invoice factoring can help improve the company’s post-acquisition cash flow. It works by financing the invoices from your slow-paying customers. Instead of waiting 30 to 60 days to get paid, you get an advance from the factor. This advance improves your cash position and provides funds to run and grow the company.
How are most acquisitions structured?
In our experience, most transactions use a highly leveraged structure. In leveraged buyouts, buyers borrow most of the money to buy the company. Buyers use this strategy because it maximizes their returns and the size of the business they can acquire. However, leveraged buyouts can be risky. A wrong turn of events can leave the company – and the owner – under water.
Acquisitions are usually financed with a combination of personal funds, seller financing, and lender financing. The personal funds contribution of the transaction usually covers 10% to 20% of the acquisition price.
In cases where the new company also needs working capital, a factoring line is included in the financing package. This approach is common in transactions where the buyer does not have funds to cover post-acquisition cash flow needs.
Need to finance a machine shop acquisition?
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.
Given the complexity of how businesses can be purchased and the products that are used, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.