Financing the purchase of a business can be a challenge. Working with experienced, local advisors who can help to creatively structure deals to implement alternatives that satisfy both buyers and sellers will help with the successful transaction of ownership.
While traditional bank financing may have been readily available when a prospective buyer had a steady income in lending for the purchase of a business, sufficient security to satisfy traditional lenders becomes a concern. If the business fails, there is no income to service the debt, and the assets of a failed business have questionable value to a bank. They don't know how and don't intend to run the business. In a bankruptcy sale, the assets can go for next to nothing.
To cover a portion of the down payment, a bank may be inclined to give a buyer a home equity loan, or a loan against other assets.
Alternatively, a bank may process a Canada Small Business Financing Loan (a program supported by the federal government), but it will be limited to 75% to 90% of the value of Furniture Fixtures and Equipment, with an upper limit of $350,000. The upper limit is $1,000,000 if real estate is included in the transaction. The loan cannot be for shares - it must be for the purchase of assets. The seller will probably end up paying more tax, as the tangible assets may represent a small part of the purchase price.
This can result in a recapture of depreciation, which is taxable as corporate income, and a taxable capital gain on the sale. This means the seller can end up with less money. There are ways to offset this that you and your advisors should discuss.
Share Sale Without Bank Financing
A different approach is a share sale without bank financing. This is where the seller finances 50% of the deal and the buyer pays 50% in cash. The banks may provide working capital secured by receivables and inventory. Since they will have security for the items being financed, they will typically agree to this.
Since the seller is becoming a lender, they should ensure they do the following:
- Insist on life and critical illness insurance on the purchaser;
- Insist on financial statements every quarter;
- Get as much security as possible, including general security agreements and personal guarantees.
The seller has security because they know how to run the business, so the assets have greater value to them. If the buyer defaults on their loan, then the seller is able to take back the business and continue to operate it until a new buyer can be found.
Our experience is that seller-provided financing is repaid in the vast majority of cases. This method also provides peace of mind for the buyer, as the note to the seller helps protect the buyer against misrepresentation and undeclared or unknown liabilities.
Other financial institutions will provide lending facilities for business acquisitions. Typically, they require the seller to finance some of the transaction behind their loan, and the seller doesn’t usually receive principle payments on his/her note until the lending institutions debt is repaid.
Sometimes, a seller can get extra cash by selling assets of the business to a leasing company, then leasing them back.
A seller and purchaser may disagree over projections and other factors affecting the value of the business. To lessen the risk of projections to the buyer, have an earn-out that bases a section of the valuation on actual future performance. This financing alternative also puts more money into the seller's pocket.
An earn-out can be structured to incentivize the seller to hit predetermined targets after the transaction closes and/or to reduce the value gap. If sales grew as the seller forecast, the seller would receive more for the business and the buyer would make more. If sales did not grow, the buyer would be paying what they perceived to be fair market value based upon the current revenues.
You can learn more about Buying a Business here or download our free Insider Tips on Buying a Business in Canada E-Guide below