This article explains how to finance the acquisition of a metal fabrication company. It provides valuable information to individuals that are going through their first acquisition. It also covers important details that help seasoned executives who are looking to grow their existing companies through acquisitions. In the article, we discuss:
- How do you finance an acquisition?
- What do lenders look for in buyers?
- Should you also buy the real estate?
- Are you acquiring new machinery and equipment?
- Sources of post-acquisition working capital
- How are transactions structured?
Typical financing sources
Most small business acquisitions, especially those under $5,000,000, are financed using one of more of the following sources.
1. Your own savings and investments
Transactions in which the buyer pays for 100% of the business in cash are very uncommon, at least in this segment. However, all buyers are expected to use some of their own funds towards the acquisition. Lenders require that buyers put some equity in the transaction, usually 10% to 20% of the price.
The 10% equity injection is an important part of the transaction and is often a stumbling block for buyers. This is because these funds cannot be borrowed or come from the seller. They must come from your savings, investments, earmarked funds that are gifted, etc.
2. Seller financing
Seller financing is a common way to finance a part of most metal fabrication business acquisitions. In this type of financing, the seller provides a loan that is amortized over a number of years. Rates and terms tend to be competitive.
Sellers prefer to offer the least possible amount of seller financing. This is understandable, as it’s in their best interest to limit the amount of funding they provide you. Providing you with financing means they have to wait to get paid. As you can imagine, sellers are not eager to wait for payment.
However, seller financing is an important tool for buyers. It ties the seller to the business, at least for a period of time. This arrangement lessens the chance the previous owner sold you a “bad” company.
3. SBA-backed lender financing
Most acquisitions under $5,000,000 use SBA-backed loans. They are an important component of most small business acquisitions. Contrary to popular belief, the SBA does not provide loans. Their programs only provide guarantees to lenders. This guarantee limits the lender’s potential losses in these loans. Basically, SBA guarantees give lenders a solid incentive to work with small companies.
Some buyers are hesitant to use SBA-backed financing due to the perception that SBA programs have a lot of red tape. This perception is based primarily on inaccurate information. The number of forms that a business buyer needs is about the same, regardless of who provides the loan.
4. Conventional bank loans
Lastly, the remaining alternative for these types of acquisitions is conventional bank loans. You can use these loans in situations where an SBA loan will not work. For example, these situations could include transactions that are larger than the SBA’s maximums.
Much like SBA-backed loans, regular loans are provided by institutions at market rates. However, these lenders are likely to have much higher collateral requirements. They also have more stringent qualification criteria.
Understand your lender’s perspective
One of the biggest mistakes you can make as a buyer is asking the lender for a loan without first understanding how they look at opportunities. Unfortunately, most buyers make this mistake. By understanding lenders, you can present the acquisition to them in a way that has the greatest chance of getting funded.
1. Can the target company support the loan?
A lender considers financing an acquisition only if the cash flows from the fabrication shop can support the new debt load. If the business cannot pay for the loan using its own cash flows, most lenders will pass on the opportunity.
2. Are the buyers qualified?
Lenders also look at the buyers very carefully to ensure that they are a good fit for both the lender and the transaction. They look at the following eight areas:
a) 10% equity investment
Lenders require that buyers pay for at least 10% of the acquisition out of their own funds. They do not finance opportunities in which the buyer is unwilling to use their own funds. Don’t expect your lender to grant an exception to this rule because you have a “great deal.” Most lenders see many supposedly “great deals” every day.
The equity injection cannot come from borrowed funds or from the seller. Some lenders can lower the equity requirement to 5% if two things happen. The seller provides financing and takes a standstill on payments until the lender’s position is paid off. In our experience, it is very difficult to find sellers who agree to this clause. Learn more by reading “How much money does it cost to buy a business?”
b) Industry experience
Lenders want to work with buyers who have experience running a metal fabrication company. This requirement creates a problem for individuals looking to buy a business without having the needed experience.
Fortunately, there is a way around this requirement. Most lenders will agree to provide financing if you hire a manager from the existing business and retain them for a period of time.
c) Personal credit
SBA-backed lenders usually require a minimum credit score of 650. This requirement often perplexes buyers. They often wonder why their personal credit is relevant in a business transaction.
Lenders view the situation differently. Businesses don’t run themselves. They are operated by their owners. Although personal credit is an imperfect measure, lenders use it as a proxy for how buyers will manage the financial affairs of the company.
d) Personal collateral
If you use an SBA-backed loan, the 10% equity contribution is usually sufficient collateral for the loan. However, having additional collateral makes your case stronger.
Lenders that don’t offer SBA-backed loans usually have higher collateral requirements. This is because their loans don’t have the government guarantee that the SBA provides.
e) Does the transaction fit their experience?
Lenders finance transactions that they are comfortable with and decline those they don’t fit their comfort levels. However, lenders have different areas of comfort based on their areas of expertise. Most buyers miss this point entirely. You can have a great transaction “on paper” and still be declined because the lender does not have experience in the fabrication industry.
If you meet the general requirements for a lender but your transaction is declined, there is strong chance that another lender will fund your purchase. It’s a matter of finding the right lender.
f) Is the transaction the right size?
Most lenders work with acquisitions of a specific size range. Transactions that are below or above the range have a high chance of being declined. As a reference, we finance acquisitions in the $700,000 to $5,000,000 range. We can finance larger transactions, but only in special circumstances.
g) Is the price/offer within market ranges?
Lenders invest only in transactions that make financial sense. They never want to finance a transaction in which the buyer overpays for the business. This could leave the lender in a bad collateral position.
During the initial underwriting of the transaction, lenders review your offer and compare it to their market experience and to industry data. Using these formulas helps the transaction move along quickly during the early phases. This method is not precise, but it helps determine if the transaction seems reasonable. You can get rough pricing formulas using the Business Reference Guide or a similar publication. For example, the Business Reference Guide expects offers to fall within these ranges:
- 75% to 85% of gross sales plus inventory
- 5 to 6 times EBIT
- 4 to 6 times EBITA
- 4 to 6 SDE plus inventory
Once the transaction progresses, lenders will ultimately ask for a professional valuation of the metal fabrication shop. They may also ask for appraisals of all the machinery, since this value is an important part of the collateral securing the transaction.
Note: here are some helpful definitions:
- EBIT – Earnings Before Interest and Taxes
- EBITA – Earnings Before Interest, Taxes, and Amortization
- SDE – Seller’s Discretionary Earnings
h) Are there customer concentration issues?
Many metal fabrication companies get the majority of their revenues from a handful of customers. This is called customer concentration and is seen as a risk for lenders. The reason is simple. The business could lose a substantial part of its revenues if a large client leaves.
Customer concentration issues affect the value of the business. Fabricators that have a diversified customer base command higher asking prices.
Are you also buying the real estate and facilities?
Buying the metal fabrication business, along with the real estate and facilities, has advantages and disadvantages. In many cases, including the real estate in your acquisition offer can make your transaction stronger.
Real estate is great collateral for lenders, and they are very comfortable with it. Furthermore, lenders can provide longer terms if 51% or more of the loan proceeds are used to buy the real estate. In those cases, the total loan value can be amortized over 13, 17, or even 25 years. This amortization period can be a benefit for many potential buyers.
However, buying the real estate also increases the total loan value. Consequently, it also increases the dollar amount of the 10% equity injection. Some individuals may have problems raising the additional equity. Remember that the increased transaction value also increases your personal risk if the company does not succeed in the future.
Working capital needs
Most buyers focus their efforts trying to fund the acquisition. However, they often neglect getting funding to handle the post-acquisition cash flow needs of the business. This oversight can create serious problems for the buyer shortly after the acquisition.
How do they finance any potential cash flow problems that occur down the road? Few buyers have additional funds they can contribute to their newly acquired business. And the assets of the business are pledged to their lenders as collateral. Consequently, the assets can’t be leveraged to get more financing. This dilemma can create a financial emergency.
We approach this situation by adding a tier of working capital financing to the acquisition funding package. We do this through a factoring financing line. Factoring works by providing funds against your accounts receivable. This financing tool improves your working capital and provides funds operate the business. Factoring can help the company deal with cash flow problems until a reserve is built.
Do you need additional machinery?
It is common for buyers to use the acquisition as an opportunity to also upgrade some of the company’s machinery. Since machinery and equipment make great collateral, lenders usually agree to this readily. It’s a matter of adding the cost of the machinery to the acquisition financing package.
By the way, you can also acquire the machinery later on as well. The acquisition financing liens on collateral should not interfere with this approach. The machinery financing company can secure their position with a Purchase Money Security Interest (PMSI). A PMSI is a specialized type of lien that enables lenders to finance goods (e.g., machinery) and retain them as collateral.
How are transactions structured?
Most transactions that we see involve buyers trying to acquire the biggest company that they can afford. This strategy maximizes the use of their own funds. The only way to accomplish this goal is to use a leveraged buyout structure.
In small business leveraged buyouts, the buyer puts 10% of their own funds towards the transaction. The remaining 90% comes from external financing. The financed component often uses an SBA-backed facility combined with some seller financing. If post-acquisition cash flow is a concern, we add a working capital tier of financing using invoice factoring.
Need to finance a metal sheet fabrication 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.