The most substantial source of financing for an EtA (Entrepreneurship through Acquisition) business will be bank financing. A quick survey of two dozen searchers finds they have raised between 35% to 75% of their transaction price through bank debt with the average being 51%, with an additional 10-40% coming from the seller. Traditional banks have become more willing to lend against historical earnings even for businesses with few assets for collateral. In the USA, the SBA (Small Business Administration) loan guarantee program has made it much easier to raise debt, and to be competitive banks have become more flexible. There is a wide variety of searcher experiences internationally that should be understood and vary widely country to country – Brazil, almost non-existent to UK which is very similar to the USA.
While debt financing 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. As Paul Thomson at Scottish American explains the waterfall, “The banks get paid off first, followed by the seller, even before the investors, and the searcher gets paid last”. Searchers report feeling a sense of obligation to pay back what they borrow much more than the funds they raise in a high-risk start-up.
Raising Bank Financing is a process
In order to secure any Bank 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. Use them to determine how much cash at closing will be needed 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 substantial level of bank borrowing and understand that their equity will be the most expensive capital you will be raising raise.
Your LOI can be used to generate a brief two 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. There is no need at this point to develop and submit a full CIM (Confidential Information Memo). The bank will advise when that is needed as you get closer to closing.
The summary sheets should show the three most recent years and TTM (Trailing Twelve Months) revenue and EBITDA, and a 3-year projection summary. Searchers who are able to incorporate into their purchase the real estate, may get advantages of longer term lengths(25 yrs) since there is a building as collateral. As a general guideline, you will want to have a 10% extra cash cushion in the bank loan to cover any surprises early on.
Additional attachments should include a balance sheet history and projections, with expected source and use of funds. Also, as things progress, prepare a data package that is self-contained and self-explanatory since often times relationship managers are not the decision maker and you rarely have access to credit officers to make your case; let your numbers make the case for you.”
Send along this request to dozens of banks to gauge their interest in giving you a commitment letter detailing their lending terms. While there are a few “Commercial Loan Brokers”, be sure you understand where their fee structure; intermediaries may get in your way of establishing a relationship with your final choice. Reach out with two or three levels of your funding request to “test the water”.
Request they sign an NDA (Non-Disclosure Agreement) to see the attachments and copy of the LOI 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. Another ended up going with a lender who had deep industry knowledge which translated into a better understanding of business nuances. One searcher had their interns reach out to 150 in their region. One searcher observes, “If you have to chase a lender it means no. Aggressive banks are always hungry; if they aren’t calling you back you’re spoiled meat!”
Next begins the negotiation process with banks about their loan amount, interest rates, terms and other requirements. In the current economic climate, it is a buyers’ market and banks are willing to be flexible on rates, fees, term lengths and covenants. Make it personal with the bank, as one searcher says, “Emphasize your own engagement and involvement with the business, this is not an ‘investment vehicle’ for you, instead a significant commitment.” Multiple term sheets are important and 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. Your negotiation process with a variety of banks should yield competitive interest rates and increased 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 and advises, “Be sure to gather multiple term sheets by running a competitive process.”
Once you see a number of term sheets from the banks and you have developed confidence in your equity raise, you can launch the Quality of Earnings (QofE) process. The banks may have some preferred QofE providers that you can select from. Tim Meng at Thorn Hill Bay suggests that “Banks will often not engage attentively in negotiations until you have at least the first draft of a QoE and it’s very hard to change their first impression, especially as there are often material changes uncovered by the auditors. (See Blog Post: Quality of Earnings).
Overall, you can expect 40 to 90 days to closing with a bank with searchers reporting an average of 60 days. You may hear a lot of promises at 30 days, but since these loans are not “standard”, you can expect extra time in loan committee, additional requests and some deeper follow-up diligence. Keep the seller in the loop on your progress and “blame the bank” for delays; the process always takes longer than you think it will.
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. Your future IOI’s will reflect this 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 as you become a “qualified and knowledgeable buyer”.
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. One searcher emphasizes that “there is more equity capital comfortable with the search model than debt capital so searchers should expect the raising the debt to be harder than raising equity.” Lenders will be skeptical of your background as a relatively in-experienced operator.
Local and regional-based banks are more interested in smaller-sized transactions and the visibility that comes from supporting local businesses, but have their own internal lending requirements. One searcher found, “I always try to deal with Local banks. They understand the area and the business way easier than out of state Banks.” Doren Spinner, at Muir Beach points out “Banks have their formulas and they follow them. Don’t spend time trying to convince a banker that even though your deal doesn’t fit their formula, it is still a great deal; just move on to the next one!”
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 Manager 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. But Ben Murray at New Forest cautions, “Be very careful about lending officers saying they will lend to just get you in the door, but change their mind when they find that it will be an Cash Flow based loan that is asset light; clarify this up-front.”
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 bank used in evaluating loans to get a better understanding of the critical numbers and formulas the lender was using in their own assessments. Learn their business methods and it will help you in the financing process. Scott Holley from EddyLine says to be bold and always “Ask for the standard loan commitment and documentation templates to search for their hidden terms.”
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. Another searcher advises, “Pick a bank that will be your partner, not just the one with the largest loan or lowest interest rate.” Ask them how they handled the Covid-19 outbreak with their customers and check references with other searchers.
Self-funded searchers can take advantage of SBA loans that allow as little as 10% equity, 75% SBA debt and 15% seller note and are very covenant light. However, these loans come with restrictions around payments to investors/sellers in the first two years and may require longer approval cycles if the bank is not “pre-qualified” by the SBA. SBA rules change frequently and are subject to broad interpretation; searchers be cautious about considering any single source as a “fact” without cross checking. One searcher pointed out, “Doing an SBA loan was a huge hassle, and took a lot of time and resources. However, there were only a few options for my deal.”
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 curious and slightly envious of the entrepreneurial independence that you have. One searcher has a specific strategy, “we likely pay 2 points over market to have a great relationship.” Loan officers may move on to other banks and entice you to “follow” them by offering better terms. Bankers want your future business and refinancing along with any referrals that you may provide to them. They are certainly less “emotionally engaged” than your equity investors, and one searcher remarked, “the bank doesn’t care nearly as much about the upside as they do about the downside. The pitch-deck to the bank may likely be very different than the pitch to investors because of these very different priorities.”
With such a high degree of funds coming from a single source, it may make sense to keep two financial institutions in the “hopper” right up until closing. One searcher was glad they did, “I dual-tracked 2 banks past the term sheet phase, when banks typically ask for exclusivity and even paid the fees in case one of the banks materially changes terms on you rather late in the game. This is more common than you might think, as some banks tend to involve their credit approvals group quite late in the game, as happened to us and we were glad to have an immediate fall-back, but only because I kept them in the process for as long as I possibly could.”
Loan Terms are similar but different from each bank
A survey of searchers reported interest rates as low as 3.5% and a high of 7% with a median of 5.0%. Many were pegged at the US Prime Rate +2.00 to +2.75 points or negotiated rates. Term lengths ranged from 3 to 10 years with a median of 7, influenced significantly by the SBA backed loans at 10 years. 60% had balloon payments with interest only in the first year or back-ended principal payments which gives searchers cash flow breathing room right after closing. Most were able to structure a working capital “line” based on a level of receivables formula. Many searchers after their second or third year are encouraged by their lender who has become comfortable with their results to refinance and pay down their investors and the seller note; another opportunity to seek out alternatives for competitive terms.
However, as one searcher points out, “the interest rate has very little impact on the returns of a deal, instead, the amount of debt influences equity turns much more. Often-times, searchers prioritize these in the exact opposite order. They get too wrapped up in the interest rate at the expense of tougher covenants.”
Andrew Mondi of Lyndhurst Capital reported that searchers may have to secure a life insurance policy on themselves to cover the loan balance which may take 4-6 weeks to finalize, cost up to $3,000 and delay closing. 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 and LOI discussions before the seller has to sign the “Subordinated Debt Agreement” a week before closing. You should expect monthly and quarterly reporting requirements and an annual review/audit as they “test” your ability to cover interest and principal from cash flow.
Loan covenants usually center around DSCR (Debt Service Coverage Ratio), must be greater than 1.25 but typically not higher than 1.75. Other covenants will include minimum net worth and total debt/EBITDA between 3x/4x over the life of the loan. One searcher felt, “You want to be able to run the business the way you see fit, so covenants are much more important that the financing terms.” Reggie Stevens at Crescent Peak says, “Consider bank covenants carefully, they are just as important, if not more important than the rates.”
“Tripping” 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! However, banks don’t want to be “owning” businesses and are more interested in seeing a “work-out plan” with you remaining in place to implement it.
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 days.
Most self-funded searchers are required that you sign personally. If this level of risk commitment is uncomfortable, you probably should not be searching. After all, they are investing in your ability to run the business and sustain the profitability that it has historically achieved. As you develop a track record with the bank, you may succeed in getting the Personal Guarantee lifted. More than one searcher has been able to have a bank drop the PG during the negotiation process.
While you may hear of schemes and techniques to “protect your assets”, the first thing a bank will do when you are in default on your loan is to pull your “personal financial statement”. If they find any discrepancy, they may hold “fraud” over your head as a much stronger motivation than the personal guarantee might have. The statement you sign may not get much scrutiny when you are applying for the funds, but does when the bank is trying to get their money back!
Funded searchers seldom sign personally for the acquisition loan, but a few 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 allow 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. Having the constant reminder from the bank of how much you “owe” 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 and cash flow.
The negotiation skill-set you develop in the search process with sellers will serve you well as you navigate discussions with financial institutions and their desire to put their own capital to work in a 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! I frequently update individual blog posts, add to the Reference section and Search tips, so visit the www.jimsteinsharpe.com website regularly
Great topic Jim and well handled. I wish I’d had such advice earlier in the game. I dealt with a number of banks in the US and Canada to build my 20 different restaurant companies. It may have been the hospitality business or as you suggest, my bankers may have been uncomfortable with my entrepreneurial independence, but even the banks that closed deals with me were suspicious to the point of insulting. I would urge your readers to have thick skins and a healthy loan to value ratios. Bankers know they are not even lending you their money. It is their depositor’s cash you are walking out with. They are touchy about that.
Barclay, Great insights, thanks for the kind words. Search on!!! Jim
I have found that rates are remarkably close from bank to bank, but fees are where the very large differences lie. The last time we did a refinancing, we put together a list of typical monthly transactions and asked each bank to give us a breakdown of their fees for those transactions. The fee differences between banks were substantial and drove the decision as to who not to use.
Chip, this is great additional input for all searchers to understand what they are getting into before they sign up with a lender. Search on!! Jim
I bought a business using an SBA loan in 2017. As I started the search, I was looking for both a business and a bank. I identified the bank before I found the business. But after I signed the LOI with the seller, I contacted his bank with his permission, and I had a short phone call with the seller’s relationship manager and I decided to switch banks. The RM knew the history of the business and the seller’s bank’s knowledge and comfort made the funding a lot easier than it would have been with a bank with no history on the business.
Spencer, Indeed, this is one of the reasons I suggest searchers wait for your LOI before reaching out to banks. Instead, devote your time in early stages of your search to prospecting for sellers. You have so much more credibility with lenders when you have as signed deal. Some sellers will encourage you to contact their bank, who already knows the stability of the underlying business. As with any process, reaching out to multiple lenders puts you in control of who you ultimately select as the lender. Search on!!! Jim