In his book Buy Then Build, bestselling author and acquisition entrepreneur Walker Diebel expresses that “acquisition is more affordable than you think.”
For many entrepreneurs, this proposition seems questionable. Buying a business certainly sounds expensive.
As with the purchase of any major asset, whether a home or a plot of land, you need money, stability and a financial plan to do so successfully and comfortably. Yes—you need cash to supply a down payment for a small business acquisition, roughly anywhere from 20% to 30% of the purchase price. What many entrepreneurs don’t realize, however, is that purchasing a pre-existing business is a more reasonable form of investment because it’s a smart and effective way to access capital.
Purchasing a pre-existing business gives an entrepreneur access to significant capital with limited savings—it’s a purchase that guarantees the attainment of income more so than other investments like in real estate.
Picture this home buying scenario. A buyer is looking to purchase a long term family home for $1 million. The buyer puts the minimum amount down (gathered from personal savings) at 20% and is approved for a mortgage with a fixed interest rate of 2.14%. Amortization is 30 years, and payments will be monthly. For years to come, the buyer will spend approximately $3000 of their monthly income to offset their mortgage and live in their home.
A key thing to recognize about this home buying scenario is that the buyer will forever use a personal, external income (i.e savings and job payments) as their monetary source to maintain their house.
How is this different from business ownership?
Generally speaking, business owners don’t use their personal, external income sources to pay for their businesses.
Purchasing a business is an alternative way to gain capital as compared to real estate because…
- When you purchase an established business and its assets, assuming that the business is financially healthy, you also acquire instant profit (pre-existing cash flow) from the business. This means that the income of the business, rather than an owner’s personal income, pays for the loans required to purchase and upkeep the business.
- Pooling capital for the down payment of a business acquisition is accessible—the weight of pooling capital doesn’t typically lie solely on the buyer’s shoulders. As the BDC expresses, “since your business is established and has revenue, you have a better chance of being approved for a loan or finding partners willing to invest in your business.” Increased access to support from partners, investors and lenders means that, as a buyer, you are less likely to have to use a considerable amount of your own initial capital to fund your investment (business).
It’s because of the flexibility of these financial factors that acquisition entrepreneurs are usually able to afford pre-existing businesses with more impressive costs than their cash savings would assume.
You’re wondering: what can I realistically afford to pay to acquire a business?
Of course, the answer is different for every prospective buyer. There’s no straight answer as it depends on the circumstances of your specific acquisition.
When calculating affordability, it’s essential to realize that you’re not working to determine if the acquisition asking price is affordable for you based on your finances.
Instead, you’re looking at the bigger picture by investigating the business’ operation and the acquisition conditions as a whole. This helps to determine whether the acquisition is an affordable, accessible and advantageous investment for you.
Such puzzle pieces include but are not limited to these factors:
- The business’ price,
- A buyer’s liquid cash
- The types of investors involved in the deal
- Conditions of financing accessible
- The business’ assets
- The business’ EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
- The SDE (seller’s discretionary earnings)
The 4 Variables That Determine Affordability
A rule of thumb: 4 overarching and interrelated financial variables work together to estimate the affordability of any business acquisition.
1. Cash Available — As a buyer, how much liquid cash do you have access to for the necessary down payment?
- There’s a percentage of cash that you will pay out of pocket.
- There’s a percentage of cash that one or more investors (eg. family or silent partners) will contribute.
2. Institutional Lending — As a buyer, how much is the bank or a lender willing to lend you?There’s a percentage of the purchase cost that the bank will loan you based on the target business and its operations.
There’s a percentage based on the business’ tangible assets? The assets may include:
- Real estate
There’s a percentage based on the business’ goodwill? The assets may include:
- Customer base
- Software systems or intellectual property
3. Vendor Take Back — As a buyer, can you obtain financing from the seller/vendor?
There’s a percentage of the total acquisition cost that the seller is likely to finance. With similar conditions to other loans, the vendor take back includes amortization and interest rates for the buyer. The BDC says vendor loans sometimes involve “an initial principal repayment postponement period of a few years.”
4. Industry Experience — As a buyer, how much experience do you have in the industry that your target business serves?
Lenders are more likely to provide loans to buyers who have meaningful, proven and specialized industry experience that aligns with target business. Lenders have more stringent terms or lending accessibility for buyers with less industry experience.
- Buyers with no experience in the target industry typically only have access to 85% of lender financing.
- Buyers > 1 year experience have 90%
- Buyers > 2 years experience have 95%
- Buyers > 5 years experience have 100%.
As a prospective buyer, you may already know the exact cash amount at your disposal— you’re itching to see some realistic percentages and numbers!
Emphasizing these 4 variables, Village Wellth has developed a user focused affordability calculator to help buyers easily forecast the financial ratios of their given acquisition opportunity. Created with realistic scenarios in mind, the calculator figures true amortization periods, interest rates and percentage ratios provided by the BDC into its calculations.
Use the affordability calculator before you begin searching for a business to compute your target search price. As an alternative, use the calculator during the preliminary review of your target business to map out different financing options and to determine the avenue that is most affordable for you as a buyer.
In order to maximize your access to capital, it’s important to realize how these 4 variables work together and inform one another. When using the calculator, experiment with numbers and the percentage ratios of these financial variables—you will see how adjustments to the variables can significantly increase or decrease an acquisition opportunity’s affordability.
Village Wellth is a proponent of buyer education and preparation. We want you to have the tools and wherewithal to craft the right financial scenario for you before you make a deal. The right acquisition opportunity is out there. You’ll be surprised when you realize what you can afford, the amount of capital available to you and how to optimize it for a prosperous entrepreneurial future.