Acquired Businesses

April 13, 2006

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In many respects, the financing options available when you purchase an existing business are similar to the options for raising capital in a growing business that you already own. Debt and equity vehicles are typically more available to you than if you were starting a similar business from scratch. Because the target business has a credit history, existing assets, an established operating cycle and business goodwill, lenders and investors can be approached in the same manner as if you were seeking to expand a business you already owned.

The major distinction between financing for the purchase of an existing business and financing to raise funds for your own growing business is that the former offers the opportunity for seller-financing. Entrepreneurs who are selling their small businesses usually realize that they may need to participate in the buyer's financing of the business sale, and they may be willing to negotiate a very favorable debt or equity arrangement with you.

Potential advantages to seller-assisted financing include:

You may get a reasonable interest rate and a less demanding credit review.
The existing assets of the business are often the exclusive collateral for the financing. In contrast to the common practice of conventional lenders, additional or personal assets of the buyer are rarely pledged as additional collateral on a seller-financed loan. Moreover, a seller's valuation of the business's assets (collateral) tends to be higher than that of a conventional lender; a low valuation might appear inconsistent with the asking price for the business.
Personal guarantees are less likely.
A seller may be willing to take a subordinate (secondary) security interest. The seller may be amenable to taking a subordinate interest to allow you to obtain conventional financing. The incentive for the seller is that the more money you can obtain from other sources, the more money the seller gets upfront. A conventional lender will require a priority claim on business assets and so the only way you may be able to qualify for the loan is to subordinate other creditor claims.
The buyer's assumption of the existing debts or liabilities of the business may be a means of reducing the purchase price. Typically, much of the downpayment or initial cash price of a business sale goes toward a reduction of existing business debt. However, rather than pay off existing creditors, those debts may be assumable by the buyer in exchange for a set-off on the purchase price of the business. The business creditors essentially become financiers for the acquisition.
The use of a gradual buyout may be acceptable to the seller. For instance, the business name and goodwill, and perhaps some tangible assets, could be sold upfront; other equipment or property could be leased by the buyer with a optional or mandatory buyout at a future time. The seller may be willing to accept an earnout arrangement, where a portion of the purchase price is depending on the future success of the business.

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As a seller, the biggest obstacle to a buyer's assumption of business debts is that the seller may remain personally liable on those debts. If the seller signed the contracts in his or her own name, committed to personal guarantees, or operated in a business form that created personal liability (e.g., sole proprietorship or partnership), the seller cannot escape these liabilities merely by selling the business; the seller remains personally responsible on the preexisting debts. Unless the creditors agreed to a subordination contract — in which the creditor agrees to substitute the new owner or entity for the former owner — the seller is unlikely to allow a buyer's assumption of debt to reduce the business's purchase price if the seller remains personally liable for a large amount of debt.