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How a Buyer Finances a Business Purchase

Cash, Third Party, Stock Swap, Merger and Seller Financing

If you want to buy (or sell) a business, you need to know what the business is worth. Once that is calculated, you need to find out how much the owner (or prospective buyer) thinks it is worth. If you can get those two numbers to line up — itself a discovery process, and an uncertain one at that — you’re going to need a way to finance the actual transaction.

Paying for a business acquisition can be structured many different ways, depending on the needs of buyer and seller. Transactions are most commonly paid for with:

  • cash
  • Third-party financing
  • seller financing
  • stock

Deal structures sometimes include earnouts (to help bridge the gap between different valuations) and payments under consulting agreements (to help transfer business knowledge, relationships, etc. as needed).

Cash Purchase

A buyer may have sufficient cash on hand and can trade money for ownership. This is a pure cash purchase. It is a simple acquisition strategy, especially when contrasted with some other methods, but it commonly does not make sense even when the acquirer has access to enough cash.

Back in a simpler era, even huge deals were executed entirely in cash. The Harvard Business Review found that as recently as 1988, nearly 60% of $100+ million business acquisitions were cash purchases. Within 10 years, that figure had dropped to just 17%. Pure cash payments remain uncommon today.

Why? Part of it is economic: interest rates aren’t as generous as they were in the 1980s, so loans are relatively cheap and using a reasonable amount of debt can boost return on investment (ROI) pretty significantly.  Part of the reason has to do with tax rules.

Sellers typically prefer cash up front, so plenty are willing to discount (lower their price) for a cash deal. Conversely, non-cash offers sometimes increase the purchase price of the business. To dress it in economic terminology, there is a premium on present liquidity on behalf of the seller.

Third-Party Financing

It is quite common for a buyer to obtain a loan (often from a bank) to help finance a transaction.  From the perspective of a seller, there is no difference at closing; it is as if the buyer wrote a check for the entire purchase price.

Prior to closing, however, there are significant differences. If you are a potential purchaser whose offer comes with a financing contingency, then your offer, all else being equal, will obviously not be as strong as an all cash offer that has not financing contingency.

Leveraged Buyout (LBO):

A leveraged buyout, or LBO, also involves third-party financing but is riskier because it involves much more leverage than is otherwise used.  In other words, the buyer puts less equity in the deal and borrows more of the purchase price.

A LBO will ultimately work only if the buyer can improve the target business’ performance enough to pay back the loan plus interest. The difference with an LBO is that debt service is much higher than outside an LBO because the amount of debt is much higher.

No business purchase is ever made with 100% borrowed money. LBOs, by definition, simply have a higher percentage of debt relative to the amount of equity the buyer is putting in. LBOs are most commonly associated with private equity transactions, but they can be used by any buyer.

Seller Financing

Seller financing is extremely common –  well more than half of all business sales involve at least some seller financing.

The seller agrees to defer a portion of the purchase price and receives a promissory note for the deferred portion.  Payments rarely stretch further than eight years, and interest rates are usually reasonable (sellers don’t want to force the buyer into default).

Seller financing is commonly used in conjunction with third-party financing, although it may be a substitute for it also. For example, a $1 million purchase price may involve the buyer paying $500,000 cash that it already had in the bank, a bank loan of $250,000, and a “Seller’s Note” of $250,000.  In this example, the bank will likely require the seller to subordinate its loan to the bank’s loan.

Stock

Sometimes, particularly when the acquirer is a very large company, it may trade its own stock for the assets or equity of the seller.  This can take many different forms:  a stock swap, a merger, etc.

Such transactions are typically far more complex than a simple purchase and involve a number of potential pros (e.g. tax efficiency) and cons (e.g. risk that the acquirer’s stock will be a good investment) compared with a simple purchase.

To read more about this topic, read this article or check out this webinar.

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