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Your Exit Strategy: Bank Debt Financing
This is part two in John Harrington’s series on succession planning for business owners. Last month we looked at the concept of seller financing; when the exiting business owner self-finances the acquisition of their business by accepting payment for the company over time. As John went on to explain, characteristics of the seller financing structure includes trust, patience, and flexibility. These three facets are not always abundant enough to make seller financing the best option. Below, he details the process of financing through third party debt for businesses that have sufficient strength.
If you are selling your company and it has both strong cash flow and a key employee well-positioned to take over the business, they may be a candidate for bank financing of the acquisition loan, even if there is a collateral shortfall. While this would result in the seller getting paid in full at closing, rather than over time like seller financing, bank debt financing will almost always result in a higher payment, higher interest rate, and a lack of flexibility. It is important to consider the overall costs and benefits of seller vs bank financing that is unique to each company.
An Inside Look at Financing
Commercial banks typically lend money for hard assets. This includes inventory, equipment, receivables, and, the all-time favorite; real estate. In acquisition financing, the underlying asset is equity, which isn’t an asset at all. The purchasing of a business manifests on the balance sheet as “goodwill,” an intangible asset representing the enterprise value of the company. Goodwill cannot be collected by a bank, therefore acquisition debt typically has a collateral shortfall; meaning there is less collateral value than loan amount, exposing the bank to a higher risk of loss.
Banks can mitigate collateral shortfalls multiple ways. The primary one is through loan term, or how long the company has to repay the loan. Most acquisition loans with limited collateral are 3 to 5 years, not 10 to 20 years like a real-estate secured loan. The much shorter term results in a much higher loan payment, but closes that collateral shortfall faster as the balance reduces quickly.
Additionally, some banks may require an excess cash flow (ECF) formula. An ECF requires periodic prepayments on the loan that results in accelerated repayment. An example formula may be 40% of all cash flow after paying costs, expenses, and debt obligations.
An example: if the Company makes excess cash of $100,000 for the year, then the Company would be required to make an ECF payment of $40,000 in addition to their typical monthly payment. This also results in the loan paying down faster than scheduled, which closes the shortfall at an accelerated pace.
Another way the Bank mitigates the risks of acquisition financing is through guarantees. It is typical for the owner of the company to be a guarantor, however acquisition loans may require additional guarantors due to the increased risk. The seller, even though they are technically not owners any longer, may be required to guarantee the loan. This is because the seller is the primary beneficiary of the loan. It is the seller who receives the loan proceeds, once the loan is funded, through payment for the seller’s equity.
By having both the current and former owner of the company provide guarantees, the bank is significantly more protected from loan losses in the event that the company should struggle to meet debt obligations.
If you would like to explore bank debt financing as part of an exit strategy for your business, reach out to a First Bank business lending expert in your area. Remember, in order to qualify your business for a loan, you will need to exhibit strong cash flow, have at least some collateral to pledge, and be willing to guarantee the loan, even after you exit the company.
Up next: In the last installment on the exit strategy series, we will look at alternatives if a business owner does not have a key employee ready to take over the business.