Reducing Cost of Capital in a Small Business Acquisition
Small Business Administration (SBA) guaranteed loans are widely recognized as one of the only reliable sources of third-party funding for small privately-held business acquisitions (up to $5 million), but do you know how this benefits the borrower’s cost of capital?
Very few small business transactions are completed in which the buyer pays all cash. This is not just because most people don’t have a big pile of cash lying around; it’s also because financial leverage lowers the overall cost of capital in any investment where an income stream is expected. And every business broker knows that it also allows a buyer to purchase a larger, more profitable business.
SBA debt financing for business acquisitions currently “costs” around 6% (interest). The cost of equity financing is much higher — typically 20 to 25% or more — depending upon the risk level of the investment. The risk is much higher for the portion not financed by SBA because if cash flow from operations declines for any reason, it’s the buyer’s cash flow (and return on equity investment) that suffers. The greater the risk, the greater a rational buyer’s expected rate of return will be. In other words, an equity holder’s cash flows are riskier than a bank’s, so they require a higher rate of return. Also, in the event of a liquidation, the debt holder has preference.
How is cost of capital calculated?
If a buyer is able to obtain 6% money from the SBA on 70% of the purchase price of a $1,000,000 business acquisition, and the buyer expects a rate of return of 25% on the remaining 30% (equity portion of capital structure), the weighted average cost of capital is:
Debt 70% x 6% = 4.2%
Equity 30% x 25% = 7.5%
Weighted Average Cost of Capital = 11.7%
This means that by leveraging the business acquisition, the buyer will see greater rates of return from the profits generated; not a bad reason to “leverage the deal.”
By the way, what amount of Fair Market Value will an SBA lender lend?
Subject to the buyer’s qualifications (of course), SBA lenders typically loan 70% (more in certain cases) of an agreed upon asset sale/purchase price plus an amount for working capital (lenders call it “over-funding” the loan). SBA regulations for 7(a) loans require that the sponsoring bank obtain an independent business appraisal from a qualified appraiser for any loan with an intangible (goodwill) value component over $250,000; or for any amount when the business is being sold to a family member. This is a great check and balance for the buyer to be sure the business isn’t over-valued.
When the appraised fair market value of the business comes in below the agreed upon purchase price, the SBA lender can still lend, but only up to 70% of the appraised Fair Market Value. Here the buyer is usually faced with two choices: (1) pay the incremental amount over the appraised value and increase their cost of capital; or (2) re-negotiate with the seller to lower the price.
“The Importance of a Proper Valuation” is the subject of my next Blog … so stay tuned.
Bob Altieri, CBA (Certified Business Appraiser) appraises businesses for SBA lenders throughout California. For additional information or for advice on a current need, please do not hesitate to call Bob.