Toronto business and franchise lawyer, Sukhi Hansra, of Hansra Law, discusses how to finance your business purchase or acquisition.
Financing to Buy a Business in Canada
Many vendors of businesses mistakenly believe that they will receive the full cash value of their business on closing. However, this is rare in sales of small to medium-sized businesses. A more common scenario is the buyer paying a portion of the purchase price in cash, and financing the rest with either a short-term loan or vendor financing.
In such cases, the vendor has a strong interest in ensuring that the buyer’s financing arrangements are well structured and flexible enough to accommodate changing needs.
Types of Financing Available for Business Purchase or Acquisitions
1. Cash or Equity On Hand.
The buyer typically provides a portion of the purchase price with cash on hand. The amount of cash required will depend on negotiations with each individual vendor. In particular, the vendor will want reasonable assurance that other forms of financing are secure enough to ensure that the rest of the purchase price will be paid.
2. Secured Loans (Senior Debt)
The most common type of loan. If your company has valuable assets or recurring cash flows, you may be able to obtain a term loan secured by those assets and cash flows. A term loan is typically a loan from a bank for a specific amount that has a specific repayment schedule and either a fixed or floating interest rate. A secured loan means that if you default on the loan, the lender will be able to claim against your security (whether assets, cash flows or both).
3. Unsecured Loans (Mezzanine Financing)
4. Vendor Financing (Vendor Takeback Note)
Vendor financing is effectively a loan given by the vendor to the purchaser to cover part of the purchase price. The buyer typically agrees to repay the vendor for any unpaid portions of the purchase price through monthly payments with interest. The benefit of vendor financing is that it is a flexible private arrangement between the buyer and seller, which can be negotiated to either party’s benefit. The buyer can also take advantage of traditional bank loans alongside vendor financing for even more flexibility.
5. Earn-Out Clause
An earn-out means that the buyer must provide subsequent payment to the vendor if the acquired business achieves certain defined thresholds (usually financial). Earn-outs can be all-or-nothing. If the threshold isn’t met, the buyer will either not have to pay or only pay a small royalty (depending on how the earn-out clause is structured). An earn-out can also be used to incentivize the vendor to train and mentor the buyer after the purchase or acquisition. The main benefit of an earn-out is that it helps bridge the gap in value perception between the buyer and seller when the valuation is uncertain.
6. Outside Investment
Instead of bearing the entire purchase price alone, the buyer may want to consider enlisting the help of others. This can come in the form of a venture capital investment, individual investors or a business partner. Outside financing is a great option where formal lenders are not willing to provide financing options (e.g. this is common in the cannabis industry).
If you will be obtaining financing in any form, you should always consider the profits of the acquired business alongside any interest payments owed. This will help you better assess the financial position of your new business after you have purchased it.
A good first step would be to speak to someone who has been through it, or someone who has helped others purchase and sell businesses – such as a Business Lawyer or Business Broker.