Buying an electrical contracting business can be an attractive option for a new entrepreneur. Construction trades have some advantages over other industries. This article covers the essential points buyers need to keep in mind to increase their chances of getting their acquisition funded. We cover:
- Advantages of a construction trade business
- Financing options
- Lender evaluation points
- Deal red flags
- Common financing structure
- How much money do you need?
1. Advantages of construction trade acquisitions
Businesses in the construction trade, such as plumbing companies, HVAC contractors, and electrical contractors, are popular acquisition targets. These businesses have several benefits that aren’t available in many other industries. These advantages include the following:
a) Resists recessions
Electricians, especially those focusing on the residential market, have some resistance to recessions. Some electrical work, such as emergencies, cannot be postponed and will be done regardless of economic conditions.
b) Cannot be outsourced overseas
Electricians are local, work with nearby clients, and are subject to local building codes. This kind of business is immune to overseas competition and will remain that way for the foreseeable future.
c) Built-in client loyal base
Many electricians have a built-in customer base. This is an advantage to buyers since it brings immediate revenues. This is one of the main advantages of buying an existing business over starting one from scratch.
d) Available to small buyers
Most electrical contractors are local, small-scale operations. Their acquisition price is under $5,000,000 and can be acquired using SBA-backed financing.
2. Financing options
Financing a small business acquisition can be challenging since buyers have only a few options. In most cases, acquisitions under $5,000,000 focus on these options:
a) Buyer’s funds
In principle, an entrepreneur can buy the electrical contracting business and pay for the total transaction using personal funds. This scenario is not practical or realistic. Instead, buyers contribute around 10% to 20% of the transaction value and finance the rest.
Note: Every acquisition must have an equity contribution by the buyer. We cover this topic in the next section.
b) Seller financing
Sellers often finance a portion of the acquisition cost. Sellers would prefer to avoid offering to finance the acquisition. However, many buyers demand seller financing as a condition for the acquisition. Seller financing ties part of the seller’s payment to the performance of the business. This shows their confidence in the business.
c) SBA-backed financing
Most transactions under $5,000,000 use Small Business Administration (SBA)-backed financing. This financing tool was created specifically to help small businesses. The SBA does not provide financing. Instead, it provides guarantees to lenders who fund small transactions. The SBA has flexible requirements. In most cases, getting a business acquisition loan from an SBA partner is easier than getting a loan from a bank.
d) Bank financing
Some banks provide acquisition financing outside the SBA’s program. These loans don’t have the SBA guarantees and are riskier for lenders. Consequently, lenders have stringent qualification requirements.
e) Family offices
Family offices can be a great resource to finance acquisitions if you find the right one. These offices can be more flexible and strategic than conventional lenders. Family offices are selective and operate through word-of-mouth referrals by trusted advisors.
3. Lender evaluation points
The most effective way to ensure a smoother transaction is to promptly meet the lender’s requirements. This section covers the six items lenders evaluate before starting their due diligence.
a) Can the business afford the financing cost?
Lenders will finance an electrical contracting acquisition only if the target company can pay for the financing costs out of its proceeds. They will not finance a transaction whose target business cannot afford the costs of financing. The risk is too high.
b) Can the buyer cover the equity injection?
Lenders require that buyers contribute an equity injection to the transaction. The equity injection covers a minimum of 10% of the transaction costs. The funds must come from the buyer and cannot be financed by third parties or by the seller. Lenders won’t finance 100% of an acquisition due to the risk. Learn about equity injection sources.
c) Can the buyer and seller provide financial reports?
Lenders evaluate the buyer and the electrical contracting company during their due diligence. Both must be able to provide three years’ worth of financial and tax reports. Being unable to provide these reports is a common red flag in small business acquisitions.
d) Are the SDE and add backs reasonable?
The Seller’s Discretionary Earnings (SDE) is a measure of how much money a new owner could take out of the business. Add backs are adjustments that increase the SDE. Basically, they are one-time expenses that are “added back” to the SDE because the new owner won’t need to incur them. These metrics are important because the SDE is often used when doing a valuation of a business. Both metrics must be reasonable and in line with the industry’s expectations.
e) Is the valuation reasonable?
Lenders will finance an acquisition only if the valuation is reasonable. They will not finance an acquisition with an unreasonable valuation, even if the electrical contracting business can afford it. Acquisitions use a multiple of the Seller’s Discretionary Earnings (SDE) as the approximate valuation target. For example, many electrical contractors use a valuation rule of thumb of 2 x SDE plus inventory.
f) Does the buyer have the right experience?
Buyers must have the right experience to qualify for financing. Ideally, they should have business ownership and electrical industry experience. However, meeting one of those two criteria is usually enough to satisfy a lender as long as certain conditions are met.
4. Common red flags
Acquiring a small business in the construction industry can be very challenging. This section discusses some of the most common red flags that can derail a transaction.
a) Missing financial and due diligence information
The most common red flag in smaller transactions is missing documentation. Basically, the sellers cannot provide three years’ worth of reliable financial and tax information. In most cases, the problem stems from the fact many small electricians don’t have a reliable record-keeping system. The only way to address this issue is to let the seller know beforehand that this information is needed.
b) Unreasonable SDE or add backs
Sellers have an incentive to show the highest possible SDE since it increases the sale price of the electrical contractor. Consequently, they try to get as many add backs as possible. This practice becomes a problem for buyers and their lenders when these get out of hand.
c) Bad reputation
Companies in the construction trade live by their reputation in the market. Buyers can have a hard time determining this. However, it’s critical that you spend time investigating the electrician’s reputation. Fixing a bad reputation is difficult and expensive.
5. Common financing structure
Most small business acquisitions rely on financing a large portion of the purchase. Buyers usually want to limit their equity injection to 10% and finance the rest through seller and SBA-backed financing. These transactions usually qualify as leveraged buyouts due to their level of financing. In our experience, most acquisitions under $5,000,000 qualify as small business leveraged buyouts. Let’s look at the most common structure in detail.
a) Buyer’s equity injection
Buyers must contribute a minimum of 10% of the project cost as their equity injection. Note that the equity injection is based on the project cost and not the business sale price. We will discuss this in the next section. Some buyers may be able to reduce their contribution to 5% if the seller also finances 5% and agrees to a standstill on their loan. In our experience, few sellers are willing to agree to a standstill.
b) Seller financing
Most transactions we finance have a seller financing component. In some cases, it is a token amount such as 5%. Few transactions have more than 15% seller financing.
c) SBA-backed loan
The last component in the package is a SBA-backed loan. It covers the remaining part of the transaction.
6. How much money do you need?
Most buyers confuse the electrical company’s sale price with the amount of money you need to buy the company. This confusion often leads to problems as the transaction progresses and the numbers add up. The amount of money you need to buy a business includes:
- Business selling price
- Capital expenditure (CapEx) additions
- Working capital additions
- Closing costs
CapEx additions refer to the funds you need to improve the facilities or equipment of the business. Working capital additions refer to the funds you need to operate the business during the initial period. Adding all these costs gives you the project cost. The equity injection, which is the amount of funds you need to buy the electrical contractor, is around 10% of the project cost.
Ready to finance an electrical contractor 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.