Developing a solid understanding of how business purchases are funded is essential for both business buyers and sellers. We encourage all business buyers and sellers to familiarize themselves with the most common forms of financing used for Main Street and Middle Market business transactions. Your BC Business Broker and local BC Business Brokers office should be very familiar with the bank lenders and the current lending environment in your local marketplace. The information below will help you with your research, but feel free to consult with your broker for more information.
Bank Financing Information
Asset Backed Lenders/Loans vs Cash Flow Lenders/Loans
An asset backed loan is any kind of loan that is secured by an asset, usually a tangible asset such as inventory, accounts receivable, machinery and equipment, etc. Cash flow loans are loans which are made against the future cash flow of the borrower. Cash flow borrowers are typically companies with minimal tangible assets; examples of these types of borrowers would be software companies, professional service businesses (such as law firms and medical practices), etc. If you are evaluating acquisition opportunities and plan to use bank financing, it is important to make an early determination as to whether you will be obtaining an asset backed loan or a cash flow loan. Most banks are asset backed lenders rather than cash flow lenders and, consequently, cash flow loans are typically more difficult to obtain.
Senior and Subordinated Loans
Senior debt takes priority over other forms of debt in the event the borrower goes bankrupt or needs to be liquidated. Senior debt typically has a first lien or claim on specific assets. Subordinated debt, which is sometimes referred to as mezzanine financing, may also have a lien or claim on the borrowers’ assets, but the lien or claim would be subordinated to the claims of the senior debt holder’s claims. Because subordinated debt is less secure than senior debt, it carries a higher interest rate. Typically, the interest rate is an additional 3% to 6% for subordinated debt versus senior debt; however, the spread or difference can be higher or lower depending on the borrower’s circumstances. Despite the higher interest rate, many Middle Market business buyers use subordinated debt rather than diluting their equity ownership by bringing in equity partners.
The “Big 5” and the Credit Unions represent commercial lenders – publicly or privately owned institutes that follow internal lending criteria. As independent organizations, their lending policies vary according to their own parameters.
Small businesses are an important part of Canada’s economy, but they sometimes face unique challenges with financing. Both the BDC and the CSBF programs offer alternatives to conventional lending:
- Business Development Corporation (BDC)The BDC operates as independent, nonprofit organization that is owned by the federal government; it exists to stimulate small business development. All BDC loans are government backed.
- Canada Small Business Financing (CSBF) LoanSimilar to SBA financing in the US, the Canada Small Business Financing Program is a federal initiative to help business owners with financing needs. Under the program, the Government of Canada makes it easier for small businesses to get loans from financial institutions by sharing the risk with lenders. Up to a maximum of $500,000 is available for any one business, of which no more than $350,000 can be used for purchasing leasehold improvements or improving leased property and purchasing or improving new or used equipment. Financial institutions deliver the program. Industry Canada does not participate in making the decision to accept or refuse your loan application.
Thinking outside the box, BC Business Brokers may sometimes suggest creative solutions to assist our clients in getting what they need. Uniting both conventional and government-backed financing often results in more leverage and greater lending ability.
Vendor Take Back (VTB)
A portion of the financing for a typical Main Street transaction commonly comes from the business seller. This form of financing is commonly referred to as “vendor take back,” “seller held notes” or “seller paper.” The amount and terms of seller financing agreements vary significantly depending on the nature of the business being sold, the general availability of third party financing, the buyer’s cash down payment and various other factors. The willingness of a seller to provide some financing is also an important psychological factor for some buyers in that it can be interpreted by buyers as a demonstration of the seller’s confidence in the future prospects of the business being sold. While the interest rate on “seller held notes” varies, we usually see rates of 6% to 10%, depending upon prevailing interest rates, and the expected repayment period.
In the Middle Market segment, sellers may provide some form of non contingent financing, but it is less common than in the Main Street segment. That said, Middle Market transactions often include an “earn-out” provision which effectively makes a portion of the business sales/purchase price contingent upon the future performance of the business. Earn-out provisions are popular with buyers in that they help mitigate the business buyer’s downside risk. They are especially common when there is a significant fluctuation in the business’ historical financial performance and/or historical to projected financial performance. Your BC Business Broker intermediary and accountant can assist you in determining what, if any “earn-out” components, should be included in the purchase price/offer for a business.
If you are a Main Street business buyer, you should also investigate the following additional sources of financing:
- Home Equity Lines of Credit
- Equipment Leasing
- Credit Cards