Posted on: November 16th, 2018
Growth in the alternative lending channel has unleashed a geyser of different loan structures for business acquisition funding. Some are asset based, some are personal credit score based and some are cash flow based. At times, the sheer number of loan types out there seems overwhelming for a capital hungry company to manage.
The three most important things to think about when reviewing business acquisition funding options are:
- Does the loan structure give you enough capital to close your deal and execute your growth plan? A loan that gives you enough now is perfectly fine to close with. But if you lack capital post-closing to invest in the business, you might quickly become overleveraged and have no ability to grow. Every company needs extra cash as a liquidity cushion.
- Does the loan give you enough time on the maturity and principal repayment? Loans that require instant repayment often choke your cash flow. The projected profits from the acquisition need time to convert into cash. Accelerated repayment can erode your working capital and prevent you from achieving long term growth.
- Does the loan overly restrict you and put the business at risk? – Borrowing base facilities can have sharp swings and create an over advance position, which easily leads to default. It makes little sense to fund a long term invest with a volatile short-term loan mechanism.
If your current loan option does not align with these three questions, it is time to reconsider your business acquisition funding option. Business acquisitions are strategically important events in the life cycle of a company. If you choose the wrong lender based on the wrong reason, your life can be very difficult.
The lender you choose may be the single most important vendor you have in your company. Their ability to provide a low risk loan and reliable support is what is needed to ensure long term success. A good lender can be discerned by a dedicated relationship approach, where they seek to learn and understand the underpinnings of your business. The wrong lender can leave you with a shaky capital foundation, ill-suited to support your long-term growth.
Here are 5 types of business acquisition loans to stay away from:
- Factoring – factoring loans are extremely expensive (over 20% interest) and have floating eligibility criteria. The loan size fluctuates based on your eligible AR and the lender usually controls your cash accounts and ability to make payments. It is never a good idea to use a factoring loan for acquisition funding due to the inherent mismatch between short term loan and long-term acquisition.
- Asset based Lines of Credit – these loans are usually very short term (
- Royalty-based loans – royalty-based loans provide the lender with additional return based on the revenue of the company. The lender takes a percentage of the revenue as part of their compensation. This can become very expensive, and highly dilutive as your company scales.
- Air ball Term Loans – this refers to the portion of an asset-based loan that is termed out by a lender, to allow you to close. The good news is that you can close, the bad news is that you must pay back this portion of the loan package within 18 months.
- Structured Equity Loans – structured equity loans are provided by equity funds and often have very enticing terms such as PIK interest and long interest only payment periods. What value these loans gives you in structural flexibility, is more than offset with their costly pricing. In addition to high interest, these loans often have expensive equity features such as warrants or minimum return requirements that will eat you out of house and home.