Learn Me: Loan to buy a business?

How do loans work when you want a loan to buy a business? 

Someone I know was trying to sell their real estate / rental business sometime last year, and the buyer was super interested, but wasn't able to make a loan work. Apparently if my friend had been willing to "leave money behind", then it would have been easy to get financing, but since my friend didn't know the person very well, he didn't want to do that. It sounds like if my friend were to "leave money behind", that would work for the bank essentially as a down payment, and the buyer would have to pay my friend back that money on a separate, shorter term loan installment. 

Apparently there was also some "magic" number or ratio of 9, that if the business was that or lower, the banks are all over the deal. Supposedly my friend's business was a 7.2. Does anyone know what this is?

Most small businesses fail.  The banks know this, and are loathe to lend money on the "business".  Inventory, equipment, real estate, not as tough, because there is a tangible value to those.  The intangible of the business, not much.

The bank has no idea how hard you are going to work, and I don't blame them for pinching pennies. I have seen a lot come and go in my 31 years on business.  I used to think, "What am I doing wrong? He has a new truck, but I don't.". Now, I see a new business with a bunch of shiny stuff that doesn't directly make money, I wait for the auction.

In reply to Streetwiseguy :

You make good points. I should clarify that the business is a real estate / rental business, so the properties are the main thing being purchased, not necessarily the company name. I'll edit my original post to reflect that.

If by 'leave money behind' they mean including some amount of "seller financing", then yes that's a thing. But that's still also a debt that I don't see how the bank could ignore.

In fact, if the buyer can come up with a down payment that is larger than what your friend owes, and your friend doesn't need the lump sum now, your friend could simply seller finance the entire transaction and keep the bank out of it all together.  This would put your friend in the preferential '1st position' rather than being in the '2nd position' subordinate to the banks '1st position'.   The seller financing could be on a short term with a subsequent balloon.  However, this doesn't mean your friend wouldn't also run some risk of having to eventually go through foreclosing on the property to get their money back if the buyer fails.

If that's not what they're saying, and that certainly would be an odd way of saying it, then I have no idea what they're actually  trying to say.  It almost sounds more like simply selling at a lower (unofficial?) purchase price that leaves equity for the buyer...And perhaps them paying the difference back at a later date?...Possibly outside of formal, and enforceable, channels?  Again, I don't see how the bank wouldn't still consider that debt when approving the loan vs purchase price percentage, especially if secured against the property the way it should be. 

Or, now that I think about it, they may be offering a higher purchase price than negotiated, with the excess being given back to the buyer as a 'cash refund'...But to the best of my knowledge, banks also tend to 'frown upon' this practice.

Whatever it is, they seem to be trying to pull some type of 'creative financing', that may or may not actually be legit.

I similarly have no idea what number for which being lower than 9 is the target.

I don't know whether it's your friend or the potential buyer actually using those vague terms, but whoever it is, they don't instill much confidence in me.

In reply to Driven5 :

Vagueness is partially because I only know part of the story, and am just trying to understand the process for my own knowledge more, and partially to keep personal details out that he might not want shared. 

The "leave money behind" does seem like a sort of seller financing. My friend explained that it makes it so that if the buyer goes under, the main loser is the seller who provided that "leave money behind" financing. With that financing the buyer would be able to come into the deal with basically no money down. So if the whole deal is sold for 1.5mil and the seller left behind 200k, I believe how that works is the loan with the bank is for 1.5mil, minus the 200k as down payment, so the seller only gets 1.3mil. Then the 200k is paid back to the seller from the buyer over a 10 year period, plus interest, of course. 

Now if I were to try the same thing just to buy a single house just for me, that type of financing a down payment definitely wouldn't work, but it sure sounded like in this case for the business it would be fine. I'm just trying to understand more. I mean the business itself is profitable, plus take into account the property value as collateral, it seems to be not a bad deal for the bank. 

Think about it as less of a loan and more like an investment for the bank.  

If it's an existing business, you'll need financial records for some number of years to show the business makes money and can therefore be able to pay back the loan as well as the operating costs.

I think this is why a lot of small owner-operated businesses simply close up and go away when the owner wants out.  They often place an unrealistic value of the business itself when it can really only make enough money to pay the owner and a few employees and not enough to pay for operating costs as well as a purchasing loan.  This is especially difficult if the business or owner owns the property it's on outright.  Then those number get really hard to make work.

In reply to Ian F :

In this case though it's a lot easier to see as it's essentially handing over a batch of investment properties. It's pretty easy to see the potential income/rent as long as you keep them filled and in working order (maintenance, the main hands on thing in the whole deal.) as well as the appraisal values of all the properties. 

In reply to AWSX1686 :

You are describing owner financing. "Leave money behind" is a weird euphemism that communicates something deceptive. 

And yes, you very much can do it in a deal for a single residential property. It's done in the vast majority of real estate deals, but it goes by a different name. It's called "Seller paid closing costs". Buyer and bank agree to a higher loan amount, seller agrees to pay some of that money back to the buyer at closing. It effectively increases the buyer's down payment. 

Business loans are very easy to get if you have enough $$$ to not need one. When I opened the Brewery, we had a small bank loan of like $100k. To this we had to pledge houses and 401k savings from all 4 partners.

Banks are NOT investors as they accept zero risk on the money they lend.

Your friend selling the business needs to consider self-financing the deal. This would give him a source of income in the form or payments and should the buyer default, then he gets the asset back. The low end car sales people have been doing this for a long time and it seems to work: just sell and repo and sell and repo.

Pete

How many properties?

In reply to AWSX1686 :

Are you trying to advise your friend the seller, or considering purchasing?  I get the feeling you are considering purchasing. 

Make sure you know as much about the business as the seller  

I once bought a business in an industry I knew nothing about. Seller knew the business better than me. He was perfectly capable of providing all the supporting documentation to make it look good on paper, and I was able to finance it easily. 

It worked out great- for the seller. Not so good for me. The business went under shortly after that, and I basically financed his debt, and will be paying on it for the next 20 years. 

If  you do not have an intimate understanding of what it takes to run and finance a rental real estate business, run away. 

SVreX said:

How many properties?

I think around 10 or so. 

SVreX said:

In reply to AWSX1686 :

Are you trying to advise your friend the seller, or considering purchasing?  I get the feeling you are considering purchasing. 

Make sure you know as much about the business as the seller  

I once bought a business in an industry I knew nothing about. Seller knew the business better than me. He was perfectly capable of providing all the supporting documentation to make it look good on paper, and I was able to finance it easily. 

It worked out great- for the seller. Not so good for me. The business went under shortly after that, and I basically financed his debt, and will be paying on it for the next 20 years. 

If  you do not have an intimate understanding of what it takes to run and finance a rental real estate business, run away. 

You are very intuitive. ;) I have an interest in purchasing, and we have talked about it a little bit, but just very surface level stuff that I've given here. So very early stages. Definitely would need more details, definitely would need more hard numbers. It's kinda crazy, but I need to do something crazy besides just a day job. 

I do already have one rental property that I live in one apartment and rent the other two in the building out (Actually bought that property from him too. Haha). Also, he is a close friend that I also used to work for (Worked for his auto repair business, but also helped him with property repairs occasionally.) so I have a pretty decent idea of what all it takes. He utilizes a rental company to manage all the properties as far as rent collection and finding tenants goes, and I also use the same company for the two apartments I rent out. I'm not the biggest fan of the rental company, but they still provide enough to be worth it. 

I definitely don't claim to know all of the in's and out's of running a rental/real estate business of that size, but I'm not totally naive either.

In reply to AWSX1686 :

That's a very good start. 

Just keep in mind.... YOU are on the hook for $1.3 million, and the bank doesn't give a crap whether you have vacancies or not. 

Correction...

You are on the hook for $1.5 million, and $200K of it is probably at a high interest rate with bad terms. 

You will have 2 separate entities with the right to foreclose if you are late. 

I would want a positive cash flow AFTER including all expenses, both loans, and a 30% vacancy factor. 

I'm willing to bet it's not a positive cash flow if you knock off a 30% vacancy factor. 

The good news is, you are young. If you can make this deal work, time will be on your side. 

Rents should rise over time, and you will have plenty of time to build equity. 

SVreX said:

Correction...

You are on the hook for $1.5 million, and $200K of it is probably at a high interest rate with bad terms. 

You will have 2 separate entities with the right to foreclose if you are late. 

200k would be a 10 year amortization, 5-7% probably. Not great, not horrible. You are correct though, the money has to be paid back and I would be on the hook for that. 

SVreX said:

I would want a positive cash flow AFTER including all expenses, both loans, and a 30% vacancy factor. 

I'm willing to bet it's not a positive cash flow if you knock off a 30% vacancy factor. 

The vacancy factor is good to keep in mind. I will definitely look at that once I have more detailed numbers. 

Keep in mind too...

This is investment real estate, not owner occupied residence. The bank rates will be higher, and so will the bank requirements. 

Mortgage insurance will not exist. Banks will require 20% down payment. That's more than $200K.  It's $300K. 

You'll want to run all the numbers, and make sure you're using valid assumptions.  A good place to start is: 

https://www.biggerpockets.com/buy-and-hold-calculator 

and

https://www.biggerpockets.com/forums 

Rule of thumb is that expenses will consume 50% of market rate rents. So make sure the mortgage payments combined are less than 50% of the rental income! That often isn’t the case. And before you dispute the 50% estimate really run some honest figures and you’ll find it’s really darn close. It doesn’t take many $10k roofs and the like to throw a wrench in things. With 10 properties you’ll be replacing a roof every couple years, a furnace every couple years, a water heater every year or so, etc etc. 

that 50% figure includes management fees, property taxes, maintenance, etc. You should have better figures available from the seller but if they’re radically lower than 50% I would be skeptical. 

Important things to know about SBA loan qualifications.

dculberson is correct that rule of thumb is 50% of full occupancy rent should be kept for capital expenses. It's very easy to spend less than that on CapEx in a single year, but you need to fill your coffers for the years when everything breaks and you're likely to exceed 50% of rent spent on CapEx.

Also saw it mentioned once, but should reaffirm that investment property will require larger down payments, will probably come with higher interest rates for the life of the loan, and will probably pay higher property taxes than owner occupied housing.

My case was different in the type of business that I purchased, (manufacturing), but my loan terms sound similar. I bought out the previous owners when they decided to retire. I had already been working here for 25 years so I knew the business inside and out, so I knew what was good and bad. The problem was that the business didn't own near enough assets to back the cost of the loan. There was a lot of goodwill involved, but that means nothing to a bank if you can't perform and continue to make money. I also did not have enough assets to cover the difference. So what ended up happening is the bank loaned me two thirds of the amount with the requirement that the owners carry the other third. This limited the banks liability while also showing that the sellers had faith in me also. In my case the sellers were the ones with the most risk, besides me, because they were second in line for any assets if I went bankrupt. 

In my case it worked out well. And the seller will probably have to do this with anyone wanting to buy unless they have enough assets to back the loan.

Make sure to do your due diligence. Hire an accountant now (not the sellers accountant), before the purchase who understands this type of business. You need a professional to go over the owners books to see what might not be immediately apparent. Based on what you have said it sounds like the price of the business is more than just the cost of the 10 rentals units. If this is the case make sure the extra cost is worth it. Asset to debt ratio and the amount of earning potential possible will make all the difference.

Good Luck

D2W said:

Based on what you have said it sounds like the price of the business is more than just the cost of the 10 rentals units.

Actually, 10 rental buildings @ 1.5 mill, makes each property 150k. Not a bad price. Plus I have to see which properties he's actually looking at selling in this deal. I think 10 or so, but I don't know his full count. It is also 10 (or however many) properties, not rental units. Each property is pretty much at least a duplex, if not a 3 or 4 unit, plus at least one 6 unit.