Financing Purchase of a Business

John Vinturella
 


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Should you decide to buy an existing business, several factors enter into consideration of how to finance it. Let us discuss the most important of these factors.

The amount of capital required.

Nearly all sales of small businesses are, strictly speaking, merely sales of the assets of the business. The buyer does not want to purchase “the business" because that would include liabilities, including unpaid taxes, exposure to law suits under the prior ownership, etc. This is not to say, however, that the amount agreed upon is all the buyer needs.

Buyers commonly underestimate the amount of capital required to purchase a business. Capital must be available not only to pay the purchase price but also for:

  • funds to operate until the business is generating cash,

  • funds to meet unexpected expenses, and

  • funds as a reserve to allow for errors in expectations.

    A buyer must think beyond the purchase price to determine the amount of capital needed. Here are some questions that must be asked:

    Do I have enough capital to pay the purchase price?

    Do I have enough capital to support 1 to 3 months’ operations-such as payroll and other cash expenses-while the business reaches a self-supporting stage?

    Do I have some extra capital to cover needs I may have overlooked (perhaps 10 to 15 percent of the purchase price?

    The type of capital required.

    The buyer must decide how much of the selling price will be covered by equity capital, i. e.investment in the business by the owner or owners, and debt capital, borrowing that must be repaid.

    If a combination is to be used, the equity capital provides a margin of safety for a lender. The greater the amount of equity capital, other things being equal, the easier it is to get debt capital.

    In purchases of small businesses, the primary source of equity capital is generally the personal savings of the buyer of the business. Few buyers, however, have enough personal savings to finance the purchase of a small business without any debt financing.

    The sources of available capital.

    An individual may borrow money for the purchase of a business by obtaining a personal loan, by borrowing against insurance policies, or by refinancing a home mortgage. These debts are not direct debts of the business, but the debts of a small business and the personal debts of the owner cannot be completely separated. Banks are the principal institutional source of debt capital for small businesses.

    The seller will sometimes finance part of the cost of the sale directly. Sometimes this can make the buyer wonder whether the seller is too interested in getting out from under the business, or if the business is as good as it looks.

    The length of time needed to pay back the capital source from the business operation.

    No matter where debt originates, a critical question is whether the business can support the debt payments in addition to all the other costs of doing business.

    Due diligence: Evidence of ownership

    The buyer should get from the seller a certified abstract of title for each parcel of real estate involved in the transaction. The abstract should be examined by the buyer's attorney. In addition to disclosing any defects in the title, examination of the abstract and the abstractor's certificate will usually show whether there are any unreleased mortgages, judgment liens, mechanics’ liens, tax liens, or unpaid real-estate taxes and special assessments.

    The seller should be asked to show evidence of ownership of principal items of personal property in the form of bills of sales, receipts, assignments, motor-vehicle title certificates, and so on. Such evidence will not prove that there are no recorded liens against the property, but lack of it should alert the buyer to the possibility that personal property in the physical possession of the seller is rented, leased, borrowed, or delivered on consignment.

    John B.Vinturella, Ph.D . has almost 40 years experience as a management and strategic consultant, entrepreneur, author, and college professor. For 20 of those years, Dr. Vinturella was owner/president of a distribution company that he founded. He is a principal in business opportunity sites jbv.com and muddledconcept.com , and maintains business and political blogs.

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