Finding the right way to finance a business acquisition can be challenging for new buyers. This article helps you understand how to finance a plumbing company acquisition and provides you with insights into how lenders evaluate these transactions. These insights help you increase your chances of a successful acquisition. We cover:
- Why are plumbing company acquisitions popular?
- Financing options for small acquisitions
- How do lenders evaluate transactions?
- Common red flags
- How are transactions funded?
- How much money do you need to buy the company?
1. Why are plumbing company acquisitions popular?
Buying existing construction-related companies is popular with entrepreneurs for several reasons. Companies in the construction trade, including HVAC contractors, electrical contractors, and plumbing companies, have many benefits over other acquisitions. Here are some of the most important advantages.
a) Existing customer base
Plumbing companies that focus on residential clients have an existing client base. Their consumers know that finding a reliable, professional, and affordable plumber is often difficult. Consequently, clients tend to stay on as long-term customers.
b) Can’t be outsourced to another country
Plumbing companies don’t need to worry about foreign competition or their work being outsourced. This type of work can only be done locally by licensed experts.
c) Consistent demand and resistance to recessions
Companies that focus on the residential market have consistent demand for their services. They tend to resist recessions because most of their work cannot be postponed (e.g., plumbing emergencies).
d) Available to small buyers
The plumbing market is segmented into lots of small and midsize companies. This situation provides an opportunity for entrepreneurs that want to acquire small plumbing companies.
2. Financing options for small acquisitions
Small acquisitions under $5,000,000 have few financing options. Institutional investors and private equity companies usually avoid financing these transactions due to their small size. Instead, small plumbing company acquisitions are financed using the following:
a) Buyer’s funds
Some buyers acquire the plumbing company by paying the total transaction cost out of their savings or investments. This strategy is uncommon since few buyers have the savings to buy a business outright. However, every acquisition does have a component that the buyer funds. It’s called the equity injection and covers around 10% of the project cost.
b) Seller financing
Most acquisitions also have a component that the seller finances. Sellers prefer to avoid offering to finance the purchase since it delays when they get paid. However, many buyers demand that the transaction have a seller financing component because it ties the seller to the future performance of the business. This strategy can help ensure that sellers don’t provide unrealistic figures during negotiations.
c) SBA-backed financing
The most common way to finance a small business acquisition is to use a Small Business Administration (SBA)-backed loan. SBA-backed loans are the most common financing option for acquisitions under $5,000,000. Although getting a business acquisition loan is never easy, SBA-backed loans have the most flexible qualification requirements. The program is aimed at helping entrepreneurs become business owners.
d) Conventional lender financing
Some small business acquisitions are financed using an acquisition loan from a commercial bank. Conventional loans are more challenging to obtain than SBA-backed loans. Banks have more stringent collateral and personal credit requirements. However, this option is useful if an acquisition does not qualify for SBA-backed financing.
e) Family offices
Some family offices provide financing to entrepreneurs looking to acquire plumbing companies. While this type of financing is very flexible, it is also hard to obtain. The best way to meet with a family office representative is through a referral, such as a mutual professional acquaintance.
3. How do lenders evaluate plumbing company acquisitions?
Lenders evaluate plumbing acquisitions carefully to ensure that the transaction is sound. Each lender has its specific in-house criteria. However, most lenders consider these five points before providing a financing proposal:
a) Can the plumbing company afford the financing cost?
Lenders want to ensure that the plumbing company has enough profits to cover the loan service. They will not finance an acquisition that does not generate enough revenues and profits to pay for the financing costs.
b) Can the buyer cover the equity injection?
Every small business acquisition requires that the buyer pays 10% of the transaction cost. This contribution is called an equity injection. It must come from the buyer’s resources and cannot be financed through another lender, the seller, or an investor. Lenders won’t finance a transaction if the buyer is unwilling to use their savings.
c) Is the company valuation reasonable?
Lenders don’t engage in transactions whose valuations are higher than market prices. Such transactions are considered too risky. Lenders use valuation experts with industry experience to determine the proper price range. However, buyers can use the following valuation “rules of thumb” for plumbing company acquisitions:
- 2 to 3.5 x EBITDA
- 2 to 2.5 x SDE plus inventory
- 2.5 to 3.5 x EBIT
- EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization
- SDE is Seller’s Discretionary Earnings
- EBIT is Earnings Before Interest and Taxes
d) Does the buyer have the right background?
The buyer’s background is an important part of the transaction. From a lender’s perspective, the whole transaction depends on the buyer being able to run the plumbing company properly. Most lenders want to see either industry-specific experience or business ownership experience.
e) Transaction size
Finance companies handle acquisitions within a certain target price range. For example, our target range is $500,000 to $5,000,000. Most finance companies won’t engage in a transaction outside their range, regardless of its attractiveness.
3. Common red flags
Buyers should always be looking for potential red flags in their acquisition. Handling problems early on can save you a lot of time and avoid wasted efforts. Here are five common red flags that affect plumbing contractor acquisitions. Note that the list is not all-inclusive.
a) Seller cannot provide reliable financial records
This problem is a common issue among construction contractors and plumbing companies. A seller should be able to produce three years’ worth of financial statements. The financial statements should properly tie in and match the bank accounts. Without accurate financial statements, a buyer cannot evaluate the acquisition properly. Note that lenders will not finance an acquisition without accurate financial information.
b) Seller cannot provide tax returns
The seller must be able to provide at least three years’ worth of tax returns. Lenders will not finance a transaction in which the seller cannot provide this information.
c) Unusually high Seller’s Discretionary Earnings (SDE)
The SDE gives buyers an idea of how much money the current owner gets out of the business. The SDE is important because it is commonly used as a business valuation tool. As you can imagine, sellers have an incentive to provide the highest possible SDE since it increases the expected price of the business. Lenders are cautious when a plumbing company’s SDE and valuation are outside a certain range. They will likely decline a transaction whose valuation is too high.
d) Questionable add backs
An add back is an adjustment to the SDE that increases the SDE’s value and, ultimately, the acquisition price. Add backs aims to account for certain one-time or unusual expenses that could negatively impact the SDE. Add backs are a common subject of discussion between sellers, buyers, and lenders. Buyers and lenders are cautious of add backs that are unreasonable or can’t be adequately justified.
e) Company reputation
Many plumbing companies enjoy recurring clients, which makes them attractive acquisition targets. Reputation in this industry is critical, though it is hard to measure accurately. Beware of plumbing companies that have a bad reputation. Fixing a reputation problem is expensive and requires a long-term effort.
4. How are transactions funded?
Most buyers want to acquire a company using financing. They do this because few can afford to put more than the minimum 10% equity injection. Consequently, the rest must come from lender or seller financing. Transactions that use 90% financing qualify as leveraged buyouts. In our experience, most acquisitions under $5,000,000 use close to 90% financing and would qualify as a small business leveraged buyout. Most entrepreneurs who buy a plumbing company use the following structure:
a) Equity injection
The equity injection has to cover 10% of the project cost and can’t be financed. Few buyers contribute more than the required amount. They prefer to keep their funds and use them towards running their new company.
b) Seller financing
Most transactions we have evaluated have a nominal amount of seller financing of around 5%. Few transactions have more than 15% seller financing.
c) SBA-backed financing
The last component of the transaction is usually an SBA-backed loan. The loan covers the portion that was not financed by the seller or covered by the equity injection.
5. How much money do you need to buy a plumbing company?
Many buyers assume that the amount of money they need to buy the business is the final seller’s price. This assumption is wrong and often leads to problems as the transaction moves forward. The total cost of the acquisition includes:
- The seller’s final asking price
- Additional capital expenditures
- Additional working capital
- Loan and due diligence costs
Capital expenditures refer to the funds the buyers need to acquire or fix equipment, vehicles, etc. On the other hand, working capital refers to the funds you need to operate the business during the initial term. You can determine the capital expenditure and working capital needs only after you’ve had a chance to examine the business. In some cases, these costs can substantially increase the total acquisition cost.
Most buyers want to provide only the minimum required equity injection. Based on this assumption, the amount of money you need to buy the plumbing business is around 10% of the total project cost, including the items listed above.
Ready to finance a plumbing company 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.