Raising Bank Debt
The most substantial source of financing for your acquisition will probably be bank financing. Typically, searchers raise 30% to 70% of the transaction price through bank debt, with an additional 10-40% coming from the seller. In the US, the SBA (Small Business Administration) loan guarantee program has made it much easier to raise debt, and traditional banks have become more willing to lend against historical earnings even for businesses with few assets for collateral.
While credit may be easier to secure, the searcher will need to fully understand the bank terms and loan covenants to keep themselves and their business out of trouble. Negotiations with the seller will focus on the value of the business, and when and how the owner will be paid and a bank will supply part of the funds. As Paul Thomson at Scottish American cautions, “The banks get paid off first, followed by the seller, even before the investors, and the searcher gets paid last”. Searchers feel a sense of obligation to pay back what they borrow more than in a high risk start-up.
Raising Bank Financing is a process
In order to secure any loan, it is crucial to start with a full understanding of the timing of cash flow requirements for the business you want to buy, including estimates for interest and principal costs. The terms of non-compete agreements, consulting or employment contracts, and seller financing are detailed in the final LOI. You then have to determine how much cash at closing will come in the form of a bank loan so that you can determine how much equity to raise from investors to bridge the gap. (See Blog Post: Raising Equity Capital).. Investors typically encourage a level of bank borrowing and will recognize that their equity will be the most expensive capital you will be raising raise.
Your LOI can be used to generate a single page “cover sheet” that outlines the sources and uses of funds at closing, and targets the size of the loan you need to have available at closing, including your working capital needs. It should show the three most recent years and TTM (Trailing Twelve Months) revenue and EBITDA, and a 5-year projection summary. In addition, you should include a balance sheet history and projections, with source and use of funds, but omit the name and details about the.
You will want to send this ‘cover sheet’ to dozens of banks to gauge their interest in giving you a commitment letter. Have them sign an NDA (Non-Disclosure Agreement) to see additional financial and operational information that you have prepared from your due diligence along with the company name. Much like the search prospecting process, the number of banks at the top of the funnel will improve yield at the bottom. Lars Gehre of Greenvault Partners contacted 38 local and regional financial institutions and got a 66% response rate, but only 33% moved forward with the NDA and 7 tendered specific offers.
You can now begin the negotiation process with banks about their interest rates, terms and other requirements. In this economic climate, it is a buyers’ market and rates, fees and term lengths are generally negotiable but typically less willing to modify loan covenants. More than one searcher has seen bank terms change at the last minute based on market conditions or a change in lending practices at the bank. Steve Divitkos at Redleaf Management Partners in Toronto decided to pay commitment fees at two separate banks to raise his confidence in getting to closing.
For the first LOI, this learning curve is steep, however, for subsequent deals, you will have developed a much better understanding of the process, terms, language and effectiveness of the lenders. Remember that most banks follow the same general loan guidelines irrespective of the borrower. Your future IOI’s will reflect a much deeper understanding of the financing parameters as you negotiate with sellers. This higher confidence level raises the level of trust in the mind of the seller about your ability to close the transaction.
Just as you have refined your Seller, Company and Investor profiles, it will be important to establish the kind of bank you want to do business with. Institutions who are aggressive and have loan quotas to fill are easier to work with, especially if they have a long history of business acquisition loans. Many banks don’t bridge the gap from auto and home loans, which are significantly different. Local and regionally-based banks are more interested in smaller-sized transactions and the visibility that comes from supporting local businesses. The right banks should be chasing you in the early stages of the process, as you will be chasing them in the final days of closing.
Getting to the right person at the bank is important and you will have to sort through titles like Vice President, Loan Origination Officer, product managers or relationship managers. They may not seem to be financially savvy, but they do hold the “keys to the vault” and make the final pitch to the Loan Committee, so you want to secure their trust in you. One searcher was turned down by two loan officers at the same bank before finding a third one in a different department who liked the deal. A small regional bank President liked the search model so much, that his bank has now closed on 3 deals in a one-year period; a reminder that “giving back” to the the search community’s by sharing of information on resources is a benefit to all.
As you develop experience with the banking language and terminology, you will be able to take more control of the process and be viewed with much more credibility by the lenders. Two searchers were even made privy to the internal valuation and underwriting spreadsheets that the banks used in evaluating loans to get a better understanding of the critical numbers and formulas the lender was using in their own assessments.
Andrew Mondi of Lyndhurst Capital and others have found that some lending institutions specialize in specific industries and have a much deeper knowledge of practices and financial ratios that are important. These industry focused lenders can be sourced once you have your LOI signed and make a big difference in securing the loan based on financial history. These lenders also can provide recommended sources of information for technical questions, QoE (Quality of Earnings) auditors as you get closer to closing. You may also find, as Lars Gehre of Greenvault did, that your Due Diligence accounting firm can have direct discussions with the bank, further raising their comfort level.
Self-funded searchers can take advantage of SBA loans that allow as little as 10% equity, 75% SBA debt and 15% seller note, but these loans come with restrictions around citizenship, payments to investors and the seller in the first two years, and generally require as long as 90 days for approval if the bank is not “pre-qualified”. Adam Barker at New Forest found that the SBA rules were subject to broad interpretation and suggests that searchers be cautious about considering any single source as a “fact” without cross checking.
Developing a “relationship” with your banker may pay off in a variety of ways. They get promoted in the bank as your own business grows and are slightly envious of the entrepreneurial independence that you have. Some move on to other banks and may entice you to “follow” them by offering better terms. They certainly want your future business and any referrals that you may provide to them.
Loan Terms are similar but different from each bank
Your negotiation process should yield a reduction in interest rates and term lengths, as Mike Donovan at East Range partners discovered when initial term sheets started at 6-7% interest/7-year term and came down to 4.9%/10-year, interest free in the first year. Ari Medoff has been seeing 3.55% fixed/3-years, then Prime plus 20 BSP from some very aggressive banks. Others are seeing 125 to 275 Basis points over prime, which has been stable at 3.25% since early 2009. In the UK rates are ranging from 300 to 600 BPS over LIBOR while in the US others have been quoted 400-475 BPS over LIBOR.
Term lengths seem to be limited in the UK and Canada to 5 years. In the US, non-SBA loans can have 10-year amortization schedules with 5-year terms, allowing for a balloon payment or refinancing in the 5th year. Many searchers after their third year have an opportunity to refinance and pay down their seller note, which typically carries an interest rate significantly higher than bank rates.
Loan collateral is typically business assets including those acquired over the loan term. Andrew Mondi of Lyndhurst Capital also had to provide a life insurance policy on himself to cover the loan balance as part of the terms. Lines of credit may fluctuate with inventory liquidation values and 80-85% of current receivables. All loans, including the seller note, are subordinated to the senior bank financing and you don’t want the seller to be surprised by this, so bring it up early in your IOI discussions. You should expect monthly and quarterly reporting requirements and an annual review/audit as they “test” your collateral levels.
Loan covenants usually center around DSCR (Debt Service Coverage Ratio), must be greater than 1.0 but typically not higher than 1.25. Other covenants will include minimum net worth and total debt/EBITDA between 3x/4x over the life of the loan. “Tripping” these covenants may mean an assignment to the “work-out group”, usually in the basement of the bank, with no carpeting, where you pay for your own coffee and sit in uncomfortable chairs answering tough questions from the “restructuring officer”; not a place you ever want to be!
Loan processing time can be critical to getting to closing with a seller – long delays and excessive approvals may give cause to the seller to walk away from the transaction if it “drags” on. Securing some references and benchmarks for closing timetables will help give you security that you can close within the promised time frame of the LOI. The fastest will be about 45 days, average 70 and some as long as 90.
All SBA loans and some others require that you sign personal. If this level of risk commitment is uncomfortable, you probably should not be searching or putting more of your personal funds on the table in your first acquisition. After all, they are investing in your ability to run the business and sustain the profitability that it has historically achieved.
Funded searchers seldom have to sign personally for the acquisition loan, but have found it necessary for later-stage loans to support business growth. Investors are seldom asked to provide any level of guarantees. In Canada, banks seldom ask for personal guarantees and in England have been known to put an upper limit on the guarantee to insure the searcher has “skin in the game”. In the UK, banks even request to meet the seller, which may be awkward, but necessary to secure financing.
Debt provides financial leverage based on assets and/or historical earnings, but comes with external “strings” and oversight that goes beyond your Board of Directors. Having the constant reminder of how much you “owe” others is a great incentive to keep focused on having a business that is “profitable and growing”, unlike the startup model that only promises future profits.
The negotiation skillset you develop in the search process will serve you well as you navigate through the financial institutions and their desire to put their own capital to work in solid businesses with a track record of profitability and cash flow generation. Remember, they need you as much as you need them.
Feel free to share some of your own best practices or experiences in dealing with these issues in the blog comments. I encourage comments and dialog, allowing all to learn from both my views and the views of others – a virtuous learning cycle. Jump right in!