Financing an Acquisition During the Credit Crunch

Several clients have recently asked whether the current condition of the financial markets has reduced the availability of financing to purchase a small or mid-sized business. The short answer is yes. However, although the credit crunch has certainly had an impact on buyers’ ability to raise money, options are still available. Below is an update on two traditional forms of financing to acquire a business:

SBA Loan Programs

One of the most frequently used sources of financing to acquire a small business is a Small Business Administration (SBA) loan. In particular, the SBA’s 7(a) program provides borrowers with access to loans of up to $2 million that can be used to acquire a business. The SBA doesn’t issue loans directly, but works with a wide range of participating lenders -- including banks and other finance companies -- to guarantee up to 75% of a loan if the borrower defaults. Last year, the SBA backed $12.7 billion in 7(a) loans.

Until recently, participating lenders would work with the SBA to issue loans to small businesses, then package and resell the loans on the secondary market. Needless to say, just like the secondary market for mortgages, the secondary market for these loans has completely disappeared. With no secondary market, some lenders have temporarily stopped issuing SBA loans, as they relied on the liquidity obtained from reselling the loans in order to make new loans. Other lenders have eliminated loans for specific types of businesses.

The Federal Reserve's July 2007 Senior Loan Officer Opinion Survey found that 65% of banks polled had tightened their lending standard for small-business loans within the past three months, and the SBA said last week that the number of loans made through its 7(a) program in the 2008 fiscal year dropped 30% from 2007.

However, there is some good news. Several larger banks with sufficient liquidity to hold loans without needing to resell them tell us that they are continuing to make SBA loans – with the caveats that the business must generate sufficient cash flow to cover a minimum of 1.2 times debt service, and that borrowers must have a minimum of two years industry experience. And the bankers we have spoken with who are no longer making 7(a) loans tell us that they expect to resume by first quarter 2009.

The other good news is that SBA loans are currently a relatively affordable source of financing.  SBA loans are priced as a fixed spread over the variable prime rate. While lenders have recently increased their spread (from around 2% to 2.5% or 2.75%), with the recent interest rate cuts, the prime rate is currently 4% - down from a 52-week high of 7.5%. Therefore, the rate on an SBA loan is now about 6.75%.

There may also be light at the end of the tunnel, as Obama has committed to support and expand programs offered by the SBA.

Seller Financing

Another frequently used method to partially finance an acquisition is via seller financing. In the past, seller financing has accounted for an average of 15% of the purchase price of a business, but in today’s environment, some expect to see seller financing increasing to an average of 25% of purchase price. While seller financing is not suitable for every situation, it can be an effective method to bridge the gap between the cash the buyer is able to raise, and the value of the business.

The most common form of seller financing involves a secured note, generally for a term of five to ten years. However, other options include real estate or capital equipment leases, seller financing of inventory or accounts receivables, and earn outs based on pre-determined milestones.

Depending on their situation, sellers may realize substantial benefits by providing financing to buyers. Most importantly, businesses that include seller financing usually sell for a higher price and sell much more quickly than businesses where no seller financing is included. The interest payments on a seller note may also provide a higher return than interest from other fixed income investments. Finally, financing may allow a seller to defer some of the tax due on the sale of the business. Of course, it’s important that the agreement includes provisions to help sellers mitigate risk and ensure they are able to collect payments from the new buyer.

In conclusion, while there are currently fewer lenders offering traditional SBA loans than in the past, SBA loans are still available to qualified borrowers. In addition, seller financing continues to be a viable option to help close many deals. Please feel free to call us for more details.