Author: Sara

The first job facing many prospective business owners is rounding up the cash necessary to make the purchase. They may find that banks have made borrowing difficult (or all but impossible), and that even SBA loans have requirements too stringent to meet. One viable option is obtaining financing from the seller; another is to seek help from family and friends.

Borrowing money from family members and/or friends is one of the most frequently-used methods of small business financing. The pluses are obvious–there is trust, familiarity, and a general comfort level when dealing with those you know. The drawbacks are self-evident as well: “doing business” with family and friends comes with cautionary notes of legendary proportions. Everybody knows that family ventures can be complex and stressful, stirring up “bad blood” and lingering ill will. However, by taking the right preventive steps, buyers can take advantage of friendly financial help.

1. Set up an informal meeting to introduce your ideas.

This is the time to “feel out” friends and relatives casually, being sure they understand that this is strictly a fact-finding (and fact-presenting) meeting. Anyone who is not interested or cannot afford to be involved has plenty of opportunity to say so without feeling obligated–or emotionally “blackmailed.”

2. Follow up with a professional business plan.

Those who have indicated interest should now be treated with utmost professionalism. A formal business plan, including detailed financials, and a carefully-drafted business contract should be presented at this subsequent gathering. Consult a business professional for help in establishing a schedule for repayment based on the appropriate interest rates. Nothing will inspire more confidence in lenders than the care taken with this vital paperwork.

3. Be clear about the structure of the business envisioned.

How much voice are investors to have in the business? This is a vital question. Be sure that all parties understand whether this is to be a simple investment or some sort of partnership, and put this agreement in writing.

4. Take care in identifying your borrowing “targets.”

Sometimes willing and eager family members can’t really afford to invest. If possible, try to spread the borrowing around so that no one person bears the crux of the loan. It may take more energy to get smaller amounts from a larger circle of people, but the safety factors for all concerned will more than compensate for the time spent.

5. Keep your investors involved.

Once the buyer becomes an owner and the new business is in operation, friends and family lenders are due more than their repayment. They will want to be informed and updated about the progress of the business. Keeping in touch is a cost-free way to return the vote of confidence your friendly investors have placed in you.

Government financing and venture capital financing account for less than one percent of all new business financing. Sixty-seven percent of all small to mid-sized businesses are financed by personal savings or friends; thirty-three percent are financed by lending institutions. The facts about venture capital financing are especially cold and hard…

• Venture capital is limited to high-growth potential, high capital-absorbing businesses.
• Venture capital benefits as few as 1000 businesses a year, and then…
• The average investment is $2.3 million, divided between 3-4 venture capital funds, which take 40-50-60 percent or more of the business’s equity.
• Venture capital investors expect the business to grow to $25-50 million within 5 years–at which time the business will go public or be sold.

Sellers generally desire all-cash transactions; however, oftentimes partial seller financing is necessary in typical middle market company transactions. Furthermore, sellers who demand all-cash deals typically receive a lower purchase price than they would have if the deal were structured differently.

Although buyers may be able to pay all-cash at closing, they often want to structure a deal where the seller has left some portion of the price on the table, either in the form of a note or an earnout. Deferring some of the owner’s remuneration from the transaction will provide leverage in the event that the owner has misrepresented the business. An earnout is a mechanism to provide payment based on future performance. Acquirers like to suggest that, if the business is as it is represented, there should be no problem with this type of payout. The owner’s retort is that he or she knows the business is sound under his or her management, but does not know whether the buyer will be as successful in operating the business.

Moreover, the owner has taken the business risk while owning the business; why would he or she continue to be at risk with someone else at the helm? Nevertheless, there are circumstances in which an earnout can be quite useful in recognizing full value and consummating a transaction. For example, suppose that a company had spent three years and vast sums developing a new product and had just launched the product at the time of a sale. A certain value could be arrived at for the current business, and an earnout could be structured to compensate the owner for the effort and expense of developing the new product if and when the sales of the new product materialize. Under this scenario everyone wins.

The terms of the deal are extremely important to both parties involved in the transaction. Many times the buyers and sellers, and their advisors, are in agreement with all the terms of the transaction, except for the price. Although the variance on price may seem to be a “deal killer,” the price gap can often be resolved so that both parties can move forward to complete the transaction.

Listed below are some suggestions on how to bridge the price gap.

• If the real estate was originally included in the deal, the seller may chose to rent the premise to the acquirer rather than sell it outright. This will decrease the price of the transaction by the value of the real estate. The buyer might also choose to pay a higher rent in order to decrease the “goodwill” portion of the sale. The seller may choose to retain title to certain machinery and equipment and lease it back to the buyer.
• The purchaser can acquire less than 100% of the company initially and have the option to buy the remaining interest in the future. For example, a buyer could purchase 70% of the seller’s stock with an option to acquire an additional 10% a year for three years based on a predetermined formula. The seller will enjoy 30% of the profits plus a multiple of the earnings at the end of the period. The buyer will be able to complete the transaction in a two-step process, making the purchase easier to accomplish. The seller may also have a “put” which will force the buyer to purchase the remaining 30% at some future date.
• A subsidiary can be created for the fastest growing portion of the business being acquired. The buyer and seller can then share 50/50 in the part of the business that was “spun-off” until the original transaction is paid off.
• A royalty can be structured based on revenue, gross margins, EBIT, or EBITDA. This is usually easier to structure than an earnout.
• Certain assets, such as automobiles or non-business-related real estate, can be carved out of the sale to reduce the actual purchase price.

Although the above suggestions will not solve all of the pricing gap problems, they may lead the participants in the necessary direction to resolve them. The ability to structure successful transactions that satisfy both buyer and seller requires an immense amount of time, skill, experience and most of all – imagination.

• Three years of profit and loss statements
• Federal taxes for the same three years
• Current list of fixtures and equipment
• The lease and related documents
• Franchise agreement (if applicable)
• List of encumbrances, loans, equipment leases, etc.
• Approximate amount of inventory on hand
• Names of outside advisors with contact information
• Marketing materials, catalogs, promotional pieces, etc.
• Operations Manual (if available)
• Brief history of business