Purchasing a business can mean that you have to raise a large amount of cash. When doing so it is important to remember that you are going to need to raise finance to cover significantly more than just the purchase price. To make a success of the deal, the funding you have available will additionally need to cover the following.

• Clearance of any debt to be satisfied as part of the deal.
• The working capital required post-sale to trade the business. It is no good buying the business only to find that you do not have the cash with which to run it. You will therefore need to work closely with your advisers to ensure that your financial projections are robust and that you raise sufficient funding to see the business through.
• Any restructuring costs that you will incur to make changes you want to put through such as redundancy costs.
• Any investments required in the business following the sale. These might range from some simple expenditure on relaunching the business under new management through to significant expenditure on updating the products, introducing new lines or replacing machinery. Don’t forget that the old owner may have been considering the sale of the business for a number of years, and it is not unknown for such owners to run the business on a harvesting strategy, whereby rather than reinvesting in the business to keep it up to date in the years leading up to the sale, instead they draw out as much of the free cash as possible for their own use. The result can be that a business requires significant refurbishment in order to ensure its competitiveness.

It’s also true to say that you will always need more cash than you thought you did, for example as below.

• Management bought out a specialist pipework manufacturer that was turning over approximately £13m. Within a year turnover had increased significantly with prospects of hitting £20m following the failure of one of its main competitors. As a result the business began to need substantially more cash than had been planned in order to support the increased levels of trading, and within a year the business came very close to collapse, only being saved by a sale and leaseback of the property which raised approximately £1m in cash.
• At the same time (and only 20 miles down the road) the managers of an electronics business had bought their plant out of a receivership. Unfortunately in this case, rather than turnover recovering from the receivership level of £30m to the expected £40m, things got worse, falling to closer to £20m. Given the business’s cost structure this translated into severe losses which there was insufficient cash to cover and as result the business failed again within 18 months.

Since neither you nor your advisers will have a 100% reliable crystal ball, you will always want to ensure that you have a significant contingency reserve built into your cash to cover the inevitable ups and downs.

This point is especially true if you’re buying a business that is in difficulty as it is likely to have stretched its creditors. Once you have bought the business you will not be able to rely on obtaining the same lengths of credit period as the business currently has. Creditors will have been giving these periods unwillingly and, on seeing that a new owner has purchased the business, will often make the assumption that there is now more cash available. You may therefore find that doing the deal precipitates a rush for payment by existing creditors, so planning your working capital must take into account provision for payments to bring overdue creditors up to date, or a plan for how these are otherwise to be dealt with.

Finally, do not forget to build into your valuation of the business, and the financing requirement shown by your cashflows, the level of interest and capital repayment in respect of the borrowing you undertake.

WHERE DO YOU GET THE MONEY?

Funding a business purchase is a large subject, but in essence there are four main sources of money to consider at the outset.

Equity

Equity will come from a mixture of:

• your own equity (which in many cases essentially means borrowing against equity in your house);
• friends and family;
• your business;
• a venture capitalist (VC) who is backing the purchasing team;
• a business angel;
• joint or co-venture partners;
• the seller, if you can persuade them to take paper (shares in your company) as payment in whole or in part, rather than cash.

Grants and soft loans

These are of particular relevance in development areas.

Debt

This is by way of borrowing against the assets being purchased.

Most forms of borrowing money to finance a business (including mortgages, leasing and hire purchase, factoring and invoice discounting, and most overdraft arrangements) require the business to provide some form of security by way of charges over business or personal assets. The level of borrowing obtainable is therefore determined by the level of security you or the business have to offer.

The only usual sources of significant unsecured lending to your business will come from credit given to you by suppliers, and any unsecured loans you or friends or family decide to put into the business.

The seller

This is by way of vendor finance (a form of debt) such as deferred consideration or an earn-out, or by paying the seller with shares in your company rather than cash.

In addition, once in control of the business you may look to run its finances in such a way as to maximise the cash retained in the business, a process known as bootstrapping. This usually involves:

• reducing or eliminating non-essential expenditure (what you don’t spend you get to keep);
• agreeing terms with suppliers that allow you longer to pay;
• keeping the level of stock held (and hence cash tied up) to a minimum;
• ensuring that customers pay you as quickly as possible so that you do not have excess money tied up in debtors.

This then allows you to build up the business’s financial reserves by retaining profit within the company and growing the shareholder’s funds.

The degree to which you believe you’ll be able to reduce the business’s requirement for working capital by use of bootstrapping techniques obviously reduces the overall amount of cash that you need to seek to raise.

Over-reliance on bootstrapping can, however, be dangerous, as for example, an MBI team bought out a £20m turnover manufacturing business. Critical to their assumptions was an expectation that they would be able to reduce both their costs and working capital requirements significantly by better purchasing. In practice they found that the old owner had already beaten suppliers’ prices down to rock bottom and there was little further saving therefore available to be made. The MBI ran out of cash and failed within a year.

Each of these sources is discussed below, but for more detail you should refer to the relevant chapters in Section B.

WHAT FORM OF EXTERNAL FINANCE IS RIGHT?

The way you finance the purchase will affect the following.

• To what degree you own and control:
  • if you are able to fund the purchase from your own resources and by raising borrowings, then the business will belong to you alone; but
  • if you fund the business by way of equity raised from a third party such as a venture capitalist, they will require a significant share of the business in return.
• And how financially stable it is, as:
  • a business with high levels of borrowings (high gearing) will have a high level of interest and capital payments that it has to make irrespective of its trading results; while
  • a similar business which you have funded from equity can in theory decide not to pay a dividend if times get tough. I say in theory, as if this is equity you have raised by borrowing against your house you will need to take sufficient out of the business to service the interest, while a VC will generally structure part of their investment as preference shares which have rights to be paid a set level of dividend.

The decision as to the appropriate mix of debt and equity is therefore a fundamental one with huge implications for the business.

If you are funding the business with borrowings then generally it is good practice to do the following.

• Match the type of finance used to what you are going to use the cash for. So to buy an asset with a long, useful life such as a property, it is better to borrow over a long period by using a mortgage so that the cost of the finance is spread over the useful life of the asset. Short-term working capital needs are better met with short-term flexible facilities such as an overdraft or debtor finance.
• Borrow long and pay short. If you think that the business can pay off a mortgage in ten years, borrow over 15 instead (making sure that there are no hidden penalties for early repayment). Then, if times get tougher than you had expected, the repayments you are committed to are less than they would have been, while if everything goes well, you can still pay off in the ten years you planned.

As with any exercise in raising external finance, doing so for a business purchase will require at the minimum the preparation of a business plan and full set of forecasts, including cashflows which act as the main tool for communicating to the finance provider:

• who you are;
• what your business does and why it will be successful;
• what you are going to do with the money;
• how much you need;
• how long you need it for;
• how you are going to repay the debts; or what return the investor will get on their equity (which for a VC will always need to involve a discussion as to the exit by which they will be able to sell their interest in the business);
• what risks the lender/investor is taking and how these are to be managed.

As a vital sales document you may well find it helpful to obtain professional advice and assistance in preparing this in a suitable form. At the same time, you should also take advice on the most appropriate financing structure for what you are proposing.

EQUITY

The money that can be raised as debt will generally be limited by the assets available to give as security. Any money that the business needs to trade, which cannot be raised as debt or grants, has to be supplied by the shareholders, either by introducing external money by investing (in shares in a company) or later by leaving profits in the business.

An equity provider is taking a risk. They are putting money into a business in return for a share in its hoped-for future success. As a result, if you seek other equity investors (such as backing from a VC firm), you will be selling part ownership of your business to others, diluting your own holding and ultimately, perhaps, your control over the business.

Raising equity is now a highly regulated business with potentially severe criminal penalties for breaches of the rules, so you should always seek legal advice before approaching potential third party investors.

Potential sources of equity for your business are as follows.

You

By investing your own cash, or cash that you have raised by borrowing against your other assets (such as by mortgaging your house).

The advantage of this approach is that you retain control of your business. The disadvantages can be that you do not have sufficient resources to fund the deal and business properly and your personal assets are now mortgaged to the success of the business.

Most individuals’ major store of personal capital is within the equity held in their personal property. When you are looking to buy a business and need to put cash in as equity, borrowing against this capital is therefore many people’s only option.

It is also true that cash raised against the security of residential property can be amongst the cheapest sources of financing available as it is raised at domestic mortgage rates.

Personal borrowing through mortgages is, however, an area that is regulated. If you are seeking to raise finance against your property you must take professional advice from an independent financial adviser or deal with an appropriately regulated mortgage broker (contact me at mark@theoss.freeserve.co.uk if you would like to be referred to an appropriate broker). In any event, you must always remember that, as it says in the small print, your home is at risk if you do not keep up the payments on a mortgage or other loan secured on it.

There is obviously an enormous number of mortgage products on the market which change all the time. It is worth noting, however, three types of product in particular, which may be of assistance in buying a business.

Fleximortgages

These are residential mortgages that provide a revolving loan against your property that can be drawn down and repaid up to a specified number of times a year without penalty. They can therefore provide a ready source of flexible funding at domestic mortgage rates, which gives you the ability to draw down your domestic equity over short periods at short notice without the high costs of bridging.

Loans of up to 85% of open market value (OMV) are generally available up to an upper capital limit of £250k (but higher loans may sometimes be available by discretion). A satisfactory prior lender reference is required, but a small amount of adverse credit history is generally acceptable. Loans are normally for up to a 25 year term and rates are similar to those of the high street.

Fifteen day mortgages

Some lenders have stripped down the search and credit referencing procedure to provide a residential mortgage which can deliver a draw down of funds within ten to 15 days from application.

Again the advances available are normally up to 85% of the property’s value on a self-certified basis, with no requirement for an accountant’s confirmation or lender reference in most cases. These loans are available to individuals with a significant adverse credit history and are for terms of up to 25 years. Rates tend to be slightly higher than normal high street levels and there will be redemption penalties.

Domestic bridging

This can be used if you only require the cash on a very short-term basis. If, for example, you believe that you will be able to take sufficient cash out of the business to repay this equity within three to six months, you might consider taking out a bridging loan rather than remortgaging the whole of your property.

Loans of up to £500k at up to 70% of OMV, with rates from 1.1% per month, are normally available from a range of lenders and can be swiftly put in place. These are, however, very short-term funds and if you have any doubt about your ability to repay the bridging at the end of the arrangement you should not go into it.

Your family, friends or others known to you

Here you have direct access to people who may be able to provide cash without incurring costs and you have some idea as to whether they are actually likely to invest. However, think very carefully about the implications of using such money and how your relationships will be affected by this arrangement (for example, what happens to your relationships if there is a business problem?).

Business angels

These are usually successful business people who have made sufficient money to have retired or sold their own business and are now interested in investing in small businesses both as a way of making money, but also as a way of continuing to be involved in business. They therefore bring not only cash but usually significant business experience and often a good network of business contacts. The downside for the entrepreneur can be that they may seek to be actively involved in the direction of the business, which can lead to conflict, so it is important to check how hands-on they want to be and how you feel about this.

Business angels are a main source of equity investment for most businesses looking to raise less than say £250,000, but they tend to be interested in investing in start-up or other early stage businesses rather than backing business purchases.

They tend to invest locally and a good business adviser will have working relationships with locally active business angels and/or can put you in contact with some regional and national networks of business angels.

Venture capitalists

Other than some smaller regional funds that specialise in smaller amounts, most venture capitalists are looking for large investments to justify their time in undertaking the transaction and funding business buy outs.

They will be looking for businesses with high growth potential and ambitious experienced management; where they can expect to be able to sell their investment on within say three to seven years by way of a sale of the shares back to the company, sale of the company or a flotation; and obtain a return on their investment of over 30% a year.

If you are looking to raise venture capital you will undoubtedly need a business adviser both to sell the proposal to the venture capitalist and to help you in structuring the deal.

Trade partners

You should think about whether there are any potential trade partners who might be interested in joining with you to purchase the business by way of a joint venture.

While this can assist in raising funds and sharing risk, you need to be careful about how this arrangement may affect your business. If you have a JV with a supplier, are you then tied to them for supplies or are you free to shop around? If you have a JV with a customer, does this give you problems with other customers who might be their competitors?

In all cases where you are bringing in outside investors you need to consider:

• how much control you are handing over;
• the need for a business adviser to help you in the process;
• how long it will take to raise the money;
• how certain you are of getting it; and
• the costs involved in attempting to raise cash (and to what degree your advisers will require an upfront payment or will work on success only fees).

GRANTS

Obtaining grants can be a long and frustrating process that involves the following.

• Finding out what grants are available for your business. This can be difficult as there is a wide variety of grants available across the country funded by local authorities, central government, European and non-government organisations such as the Prince’s Trust. To find out what is available in your area contact a business adviser or your local Business Link, or log on to www.j4b.co.uk which has a facility to search for grants by postcode.
• Finding out if you have to apply before you incur the expenditure. Many grants are not retrospective.
• Finding out if you can obtain cash prior to the expenditure. Many grants provide repayment to you of part of an expense or investment that you have to make and cannot be retrospective.
• Completing the application process, which you will generally find includes attempting to estimate how many jobs will be created, or staff helped to obtain NVQs etc, as a significant part of the form of selection criteria.
• Awaiting approval of your application and payment of the funds required, which may take some time.

All of the above tend to suggest that grants will have little relevance to most business purchases, although they may well be important for funding investment required downstream.

Nevertheless there are some occasions, particularly in relation to buying out businesses from insolvency, where grants can play an important role, particularly Selective Finance For Investment in England. These grants are made towards capital expenditure, where all other sources of funds have been exhausted, and are available in what is known as Tier 2 and 3 development areas.

Be careful if you take up such a grant, however. The terms will normally make specific reference to the number of people employed. This can cause a problem downstream, as for example an electronics business MBO had obtained sizeable grant aid which specified that it was to secure 600 jobs. When the industry suffered a downturn and its competitors laid off staff, the company was unable to do so as this would trigger repayment of the grant. The company staggered on without reducing its cost base until eventually it failed.

There are, however, two sources of government funding or support that you should be aware of.

• The DTI operates a department called the Redundancy Fund which will step in to pay employees for statutory redundancy in the event of insolvencies. What is less well known is that if persuaded that by making some staff redundant, other jobs can be preserved, the Redundancy Fund will sometimes lend companies the money to make statutory redundancy payments, with repayments typically over a three-year period. If you anticipate needing to make redundancies as part of a restructuring, this may therefore be assessed in meeting part of the cost.
• The DTI also operates the Small Firms Loan Guarantee Scheme (SFLG) under which a business which has a viable business plan, but which is unable to get bank lending due to lack of available security, can have the borrowing underwritten by the DTI. Again this is not really of relevance to raising the finance for the immediate purchase of the business, but may be of great assistance in helping to fund the ongoing working capital or future investment in the business.

DEBT

The finance you can raise by way of loans against the company’s assets will comprise a structured finance package of borrowings against its:

• property by way of commercial mortgage, or sale and leaseback;
• plant and machinery by way of sale and leaseback; and
• debtors (and sometimes stock) by way of a factoring or invoice discounting facility.

Providers of this type of funding include the following.

• Banks, which will have a range of financing subsidiaries (and don’t forget that you will also need a trading bank account anyway). Banks are, however, unlikely to want to fund such deals by way of overdraft facilities.
• Package lenders, who are normally invoice discounters who are also able to offer financing against property and/or plant and machinery, as well as in some cases stock. While such funders are key to many successful MBO/MBIs, some limit their overall exposure to a certain percentage of debtors (for example by being no more than 150% of the debtor book value).
• Stand alone independent specialist funders who will finance against any one particular class of asset (such as a factor to cover debtors, a building society to lend on the property, and an asset financier to cover the plant and machinery). Some commercial finance brokers specialise in putting together packages of such funders in order to provide greater financing (headroom) than use of a package funder alone.

The types of borrowing available are discussed in more detail below, but the levels of advance available are generally the following.

• Property – 70%- 85% of the OMV by way of a commercial mortgage, or 100% by way of a sale and leaseback, which therefore removes the requirement to fund the deposit out of equity. In fact in some cases the actual sales price achieved can be well in excess of the surveyor’s OMV for borrowing purposes, resulting in an injection of working capital into the business at the outset.
• Plant and machinery, from 70% to 100% of the machinery’s valuation dependent on the lender, on a three to five year sale and leaseback basis.
• Debtors, up to 85% of available debt, which is to say of the right type, under 90 days old and subject to credit limits etc.
• Stock will be by way of an increased ability to draw down against debtors (say up to 100% or more of the debtor book) but such borrowings will only be against finished goods stock.

The basic information that an asset finance broker will need to establish how much debt funding can be raised for purchase is set out below.