What is the minimum down payment to buy a business?
When you’re buying a business, the size of your down payment matters because it has an impact on your finances for years to come.
While there’s no simple formula for calculating the “right” size of a down payment, Jade Hipson, Senior Account Manager at BDC says it’s important to show you have some skin in the game.
“A lot of parties are being asked to take a risk on you—lenders, investors, even the buyer,” Hipson says. “The best way to show your commitment to these parties is to have a significant down payment.”
She says a good rule of thumb is for the down payment to cover 20% to 30% of the purchase price. Even then, lenders will often take it into account that a seasoned entrepreneur is likely to have different financial means than someone who’s just getting started, so the percentage can vary.
Overall, lenders are looking for a meaningful commitment in some form.
Someone who has worked in a company for many years and now wants to buy the company or a part of it, for example, will sometimes be able to purchase the company with a smaller down payment. In this situation, the buyer could argue they are less risky than a pure outsider. This could sway a lender to lower their requirements for the shareholder investment.
If lenders do not want to proceed with a new shareholder who doesn’t have significant funds to invest, one solution can be for the buyer to purchase the company over time. In these situations, the vendor will slowly sell off shares to the buyer and gradually exit the business.
Where does the rest of the money come from?
If you’re putting down 20% to 30% of the purchase price, the remaining funds can come from a few different sources.
A bank loan
Also called “senior debt,” this is a common way to cover a portion of the purchase price. This kind of loan usually has a set repayment schedule and relatively low interest rate compared to other options. The terms and conditions will depend on a variety of factors, including the size of your down payment, available collateral and expected business performance.
A low interest rate often comes with strict repayment terms that you can only fulfil if your business performs well right out of the gate, and that often doesn’t happen, so adding in flexibility is important.
Also called “junior debt” or “subordinate debt,” this is a more flexible type of loan that can be structured in many ways—and sometimes even treated as equity, effectively increasing the size of your down payment.
This type of debt offers repayment terms adapted to a company’s cash flows, and targets a return on investment that will be more expensive than senior debt but will have flexibility in how that return is achieved (i.e. a mix of a lower coupon interest rate plus a variable return, such as a bonus or a portion of royalties).
Mezzanine loans rank below secured debt in repayment priority in case of default.
Also called “vendor financing,” this is an attractive option when you want to add flexibility to your financial structure. In this case, the person selling the business takes a portion of the price upfront and agrees to be paid the balance at a later date, often after much or all your senior debt is paid off.
That balance is usually secured through a lien on the property and assets of the company. If the buyer defaults on their payment obligations, the seller can step back in and take over the business, in some cases.
Often, seller and bank financing are combined. In this case, the seller’s lien is subordinate to the bank’s. Another type of seller financing involves conditional payments, such as stock options or additional payments (earn-outs), if specified performance objectives are achieved. These provisions help keep the seller tied to the company’s future success, which can be useful to ride out the usual surprises that arise during the early transition years.
What do I need to do before I buy a business?
Hipson offers these six tips for entrepreneurs preparing to buy a business.
1. Perform due diligence
When you find a business you want to buy, the first thing you’ll want to do is perform proper due diligence. Learn everything you can about its financial and legal situation as well as its future outlook. You should use the services of in-house and outside experts to do this.
This will allow you to understand the strengths and risks of the transaction and clarify where you will need to focus your efforts after the transition.
Understanding the cash flows of the company is key, most importantly to help you plan accordingly, but also for your lenders who will be looking to structure their loans based on your forecast.
Creating an overly optimistic forecast will not help you, as you could end up in trouble if you are not hitting your targets and your financial payments have been tied to those targets. Building flexibility into your financing structure is key, as is having a patient financial partner support you through the turbulence of a transition.
2. Choose investors wisely
“Do your homework on the lenders and investors who show an interest in financing your transaction,” Hipson cautions. “Many investors want to put their two cents into the operations of the company, so it's integral you choose those who match closely to your own operational goals and ideologies.”
3. Find answers for your lenders
Before accepting to finance a transaction, you bankers will need to see a business plan detailing where you want to take the business as well as financial projections for the next 12 to 18 months. Here are other questions your bankers may ask.
- Why is the owner selling the business?
- Is it a share purchase or asset purchase?
- How was the selling price established? In other words, what is the business worth and how did you determine that value? (An outside valuation report, a multiple of EBITDA, etc.).
- What is included with the purchase price? Any hard assets or is it all goodwill? (Different financing instruments are available depending on if you have security or not to offer)
- What is your experience in this industry? Have you ever worked in the company being acquired? If so, in what position?
- Do you have access to the financial statements of the company being acquired? What is the financial health of the company? Do you understand how the company’s financials compare to others in the industry?
4. Look beyond interest rates
Interest rates matter, but other terms, conditions and flexibilities can make for a better deal over the long run. “A low interest rate often comes with strict repayment terms that you can only fulfil if your business performs well right out of the gate,” Hipson says, “and that often doesn’t happen, so adding in flexibility is important.”
The cheapest loan isn’t always the best loan, she adds. For example, the possibility of postponing payments on your loan’s principal can help you maintain healthy cash flow in your business. Another example of flexibility is loan repayments tailored to the ups and downs in the cash flow of a seasonal business.
You may also want to consider mezzanine lending, which is a very patient option for a business transition. With a mezzanine loan, some or all of the principal can be structured as a balloon payment after a period of time, with options to pay down principal earlier if certain metrics/covenants are met.
5. Plan for disruption
The first few years of a business transition are tough. There are always surprises. If a key member of the team decides to leave after your acquisition, sales go down or a key piece of equipment fails, you need the wiggle room to deal with those hiccups without putting yourself at financial risk.
6. Surround yourself with experts
Hipson says that when it comes to buying business, the more you know, the better. She adds that it’s important to talk to a trusted banker, financial advisor or consultant as soon as you start thinking about buying a business. They can help you sort through the options, make key connections and ensure you’ve thought out various scenarios.
“If you don’t talk to someone, you won’t know what options you have,” she says.