The equity injection is the funds that a buyer contributes to a business acquisition. Equity injections are commonly required in transactions that use lender financing. In this article, we cover:
- What is an equity injection?
- How are equity injections calculated?
- Why are they required?
- Can the equity injection be financed?
- Common equity injection sources
- Exceptions to the rule
1. What is the equity injection?
Most business acquisitions that use lender financing require that the buyer use some of their own funds towards buying the company. This buyer contribution is known as an "equity injection," though some buyers also refer to it as a "down payment."
Most SBA lenders require a minimum equity injection of 10% of the total project cost in most cases. Some lenders, especially those that don't provide SBA financing, require higher equity injections. The injection size depends on the transaction details, the risk profile of the transaction, and the risk tolerance of the lender.
2. How to calculate the equity injection
Most buyers assume that the equity injection is based on the loan amount. This assumption is incorrect. The equity injection is based on the total transaction cost. The total transaction cost includes:
- Cost of the business
- Additional capital expenditures (if any)
- Extra cash flow for operations (if any)
- SBA guarantee (if any)
- Other transaction costs
Calculate the total transaction cost by adding all the costs of buying the business. The equity injection is usually a percentage of that amount.
Here is an example to illustrate the point. Let's assume two hypothetical transactions with a total cost of $1,000,000 each. We will call them opportunities A and B.
- Opportunity A: The buyer gets $400,000 of seller financing and needs to finance the remaining $600,000.
- Opportunity B: The buyer does not get any seller financing and needs to finance $1,000,000.
Both opportunities have the exact same total transaction cost. Consequently, both buyers need an equity injection of $100,000, which is 10% of $1,000,000. Note that the amount of seller financing they negotiate and the size of the loan they request are not used in the calculation.
To learn more, read "What is the cost of buying a business?"
3. Why is an equity injection required?
Lenders require an equity injection because it lowers their risk. This protects them and benefits the buyers because it enables lenders to charge lower rates. The three main reasons lenders require an injection are:
a) Protects against value drops
The injection provides the lender with a financial cushion that protects them against drops in the company's value. This cushion allows the acquisition to absorb a modest drop in value without affecting the lender's principal.
b) Shows buyer commitment to the transaction
The injection shows that the buyer is committed to the purchase and will stay on if the situation becomes challenging. Experience shows that buyers who have not committed funds have no incentive to stay on if things become difficult. Remember that a lender never wants to be in the position of taking over a troubled business.
c) Covers valuation differences
Lastly, the equity injection covers any valuation differences between the seller, the lender, and the buyer. Let's assume that a seller wants to sell their business for $1,000,000. However, after an appraisal, the lender considers that the company is worth only $800,000.
The lender will base its financing offer on the $800,000 valuation. This situation leaves a $200,000 gap needed to meet the seller's pricing requirement. The transaction could be structured as follows to cover the difference:
- Lender valuation: $800,000
- Seller price: $1,000,000
- Loan: $720,000 (90% of $800,000)
- Equity injection: $280,000 ($80,000 + $200,000)
4. Can I finance the equity injection?
Buyers cannot finance the equity injection. The funds cannot come from loans or the seller. Allowing equity injections to be financed defeats one of the primary purposes of having them in the first place. The buyer would not have any of their funds committed to the transaction. Consequently, they'd have no financial incentive to stay on if the business runs into problems.
5. Equity injection sources
Funds for the injection come from personal sources. The most common equity injection sources include:
a) Personal savings
Many buyers start saving for their acquisition years before they can actually purchase the business. They diligently save a portion of their salary every month and put it in a savings account. They never touch the money and accumulate as much as they can. This method is probably the best and safest way to get the funds. It can also take several years to reach the objective.
b) Personal investments
Buyers can also liquidate existing investments in stocks and mutual funds to cover the cost of the equity injection. Like using their savings, this option requires the diligence to build an investment account up to the right amount. This method has some risk since investments can fluctuate and lose value.
c) Working with partners
Buyers who don't have sufficient funds can also consider partnering with affluent individuals. Keep in mind that the partners are also owners in the business and must meet all of the financing requirements.
d) Retirement funds
In principle, a buyer could liquidate their retirement savings (e.g., 401K, IRA, etc.) to pay for the equity injection. We consider this option – for most buyers – too risky. The buyer is betting their retirement on the success of the acquisition. Unfortunately, the risk of a negative outcome could have serious consequences.
e) Home equity
In some situations, a buyer could extract equity from their homes to pay for the equity injection. Common options include refinancing the home or getting a Home Equity Line Of Credit (HELOC).
Much like using your retirement funds, this strategy is too risky for most buyers. Ultimately, the buyer is betting their home that the business will be successful.
A word of caution
Using retirement funds or home equity to pay for an equity injection can have serious consequences. Consider speaking with a qualified financial professional (e.g., CPA) before taking any action. A professional can help you determine the best solution for your situation.
6. Are there any exceptions?
In most cases, you should anticipate paying 10% or more of the transaction value as an equity injection. In some cases, SBA-backed lenders can reduce the equity requirement to 5% (instead of 10%) if the transaction meets two conditions. To qualify for this requirement, you must obtain a:
- Minimum amount of seller financing
- Standby on the loan from the seller
A "standby" is a clause in which the seller agrees to collect their loan only after the acquisition lender is paid off. Consequently, if the bank's acquisition loan is for 15 years, the seller may have to wait that long until they see the first payment. We have yet to see a seller agree to this provision, though it may happen from time to time.
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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.