You’re on the verge of buying an SME as part of a business transfer and negotiations are coming along well. Before your dream can come true, you’ve probably got one more step: convince the bank to help finance the transaction.
Remember that, first and foremost, when financing a project, the lender’s priority is to minimize its risk, particularly considering that an ownership transfer is a fairly risky event in a business’s life.
That being said, as a transferee (we’re using the singular here, even though you may be several partners), you have an advantage over someone who’s just starting a business. The company you want to buy already has a history, its revenues and profitability, clients, etc. are known quantities. You have tangible information to support your application.
The company’s background is a key element in analyzing a business financing project because different criteria apply depending on how old the company is. SMEs that are less than five years old are generally considered to be more sensitive, as they are riskier.
Lenders also consider the size of the transaction, which will impact their requirements. In the case of smaller transactions (under $500,000), for example, the lender will look at a few key indicators, such as the transferee’s credit and net worth and could require personal guarantees. In this type of transaction, the lender could also analyze the transferee’s ability to inject funds to support the business and cover any contingencies.
A solid team is key
If the lender is satisfied with the financial aspects of the application, he will then undertake a qualitative evaluation. This is when he will take a close look at the quality of the transferee’s management team, including:
-The transferee’s entrepreneurial experience and knowledge of the targeted company. If the transferee is already in the company (family member or employee), the risk is lower, since the transferee already knows the business and its industry;
- Whether key employees are identified and if they will remain;
- The transferor’s commitment to stay on to ensure a smooth transition;
- The presence of an advisory committee, ideally with the transferor on board;
- Whether the transferee is supported by a professional accountant and is receiving outside help (specialists, mentor, etc.), particularly if he has any managerial weaknesses.
Make a good impression
The fewer unknowns in the project, the greater the financial institution’s confidence will be. Be prepared and properly supported. You need to carefully plan the business’s transfer and development.
The financial forecasts must be well developed and based on solid assumptions.
Beyond the numbers though, it’s critical that you make a good impression with the lender. You have to prove that you’ve asked yourself the right questions and found solutions to offset any weaknesses. For example, talk about the support you have (transferor’s involvement, advisory committee, support from a professional accountant, etc.), especially if you’re an external transferee and don’t know as much about how the business operates or its industry.
Our team can help you with complex steps, such as evaluating the business, performing the pre-purchase investigation and determining the strategic issues and business plan.
Hint: To accelerate the processing of your financing application, get the lender involved early on, that way the process won’t be delayed if he has additional questions.
The balance of sale
Another key component of the business transfer financing process is the balance of sale. This is the total transaction amount that will have to be subsequently repaid to the transferor, in accordance with the terms set at the time of the sale.
This is often a major issue during the transfer negotiations. The transferor wants to minimize the balance to reduce risks, the transferee wants a higher balance to keep short-term financing requirements as low as possible.
Most of the time, the lender’s preference is that the transaction include a balance of sale in order to limit its fund injection and share the risk evenly between the three parties: lender, transferor and transferee. The balance of sale takes on greater importance with a less-experienced transferee with limited financing. Furthermore, if there is a balance of sale, it’s in the transferor’s interest to stay on board and support the business’s operations, which also reduces the lender’s risk.
The balance of sale is calculated using the debt ratio, and in a business transfer should not be greater than 3:1, i.e., debt should not be more than shareholders’ equity times 3.
In some cases, the balance of sale could be considered as shareholders’ equity if paying the bank loan has priority. Consider a $400,000 transaction with a $250,000 loan, a $50,000 injection from the transferee and a $100,000 balance of sale. The balance can’t be paid until the loan has been repaid, which reduces the lender’s risk. The balance of sale improves the overall financing application and makes it easier for transferees with limited resources to become shareholders.
If you’re planning to transfer your business, our experts can help. Contact them today!