How to Finance

FINANCING THE ACQUISITION (of commercial property or residence property)

What you will find here:

• Types of financing
• Debt/equity allocation
• Preparing the loan proposal
• Sources of financing
• How to negotiate your loan

Correctly financing the acquisition is critical to both the seller and buyer. Some sellers view financing as only the buyer’s problem and insist on an “all-cash” sale. They overlook the import of financing in the buy-sell process and fail to work with the buyer shape the financing that can best serve their respective needs. The net result is that the business stagnates on the market and forces the seller to negotiate with endless prospects before one is found with the required cash .More often, in desperation, the business is sold at a bargain price.

Financing is seen by the seller as a way to get paid for the business. For the buyer, financing must mean considerably more. More business fails because of improper financing than most other factors. Improper financing also restricts growth, creates tax problems and even causes conflicts between partners.

Financing centers on seven key questions:

1) How much capital is need?
2) How should the invested capital be divided between borrowed and owner funds?
3) Are partners preferable to borrowing – and if so. What is a fair partnership deal?
4) What are the best sources for acquisition financing?
5) How do you apply for a business loan?
6) What term should be negotiated?
7) How should the loan be structured?

Accountants and attorneys may have some experience arranging financing for their clients. Their specialty and prior financing involvements with other clients determine their usefulness as financing advisors.

Business finance is not a simple subject. As with valuations, it is a specialty and poses complexities that may be beyond the buyer and his advisors.

Financing the small business acquisition usually comes from three primary sources:

1) Internal Financing. That part of the sales prices that is financed by the seller through the assumption of debt or similar financing opportunities that exist within the business and are made available to buyer.
2) External Financing. Funds borrowed from external sources such as bank, SBICs, and similar lenders.
3) Equity. The amount invested by the buyer.

The buyer must first investigate the available internal internal financing for only then can be estimate the capital that must come trough other sources, including his own personal funds.

Consider, for example, the business selling for $1000.000.The buyer without internal financing has a $100.000 problem. However, if the buyer negotiates a $70.000 loan from the seller and assumes $10.000 in trade debt, the buyer suddenly reduced the problem to only $20.000.

Financing must go beyond what is required to buy the business. The buyer also must forecast the working capital needed to ensure fiscal stability and to grow the enterprise. Buyers who overlook this point mistakenly approach financing as a two- steps process. They first exhaust their capital or borrowing power to buy the business and later look for financing to build their business. There are usually unsuccessful because their collateral is already pledged and the original financing cannot be reshaped to accommodate additional financing. A buyer should incorporate working capital into the initial financing.

A buyer should closely examine the balance sheet to see what assets and liabilities can release cash and reduce the need for outside financing.
Excess inventory, for example, may be partially liquidated. If the buyer will not assume the seller’s debts, the cash flow projections should reflect this as available credit. Buying the seller’s receivables affects financing because receivables creates an immediate income stream.

The buyer also must determine how to allocate financing between external debt and equity. For many buyers, the answer is decided by their own limited funds. Whether or not preferred, leverage is the only way these buyers can afford to buy. The well- capitalized buyer must determine whether or not to use more or less of his own funds.

Leverage is the trend in small- business acquisitions. Buyers prefer to invest as little of their own money as possible. This can be seen even with large- business acquisitions. About half of all such acquisitions are made with an equity investment of five percent or less. More than 95 percent is debt financing. Why is this so? There are three reasons:

1) RISK. Buyers are, and should be risk oriented. Invested capital is capital at risk – a discomforting thought few buyers overlook. Even though these same buyers may be personally liable on the financing they gain some protection because the loans are collateralized with business assets. The buyer’s liability is then limited to any deficiency should the business fail.

2) RESERVE CAPITAL No matter how carefully the capitalization requirements are forecasted, a business inevitably demands additional capital. Leverage allows the cash- shy buyer to retain a contingency fund for these unanticipated cost.

3) TAX ADVANTAGES. INTEREST PAYMENTS ON BORROWED FUNDS ARE TAX DEDUCTIBLE. THIS IS OF CONSIDERABLE IMPORTANCE TO THE BUSINESS WITH SIGNIFICANT PROFITS.

These are only few advantages to maximum financing. The decision to borrow heavily also may be motivated by the desire to invest excess funds in other ventures.

The importance of the well- prepared loan proposal to successful financing is apparent. Most loan applications are refused only because they fail to provide the lender sufficient information to justify the loan. Large corporations understand the need for a well- documented loan proposal, but buyers seeking capital to buy the smaller firm too often approach a lender as if they were seeking a car loan or a home mortgage.

Preparing a well- documented loan proposal is not difficult. Most of the information and documentation will have been gathered during the evaluation stage and only requires logical compilation to give the lender the information he will need on five main points:

1) CREDIT AND PERSONAL HISTORY
* name and address
* marital status
* employment history
* education
* personal assets and liabilities
* military status
* bank references
* credit references
* outstanding lawsuits
2) BUSINESS HISTORY
* name and address of business
* narrative description of business
* history and age of business
* financial statements for prior three years
* tax returns for past three years
* summary of proposed business changes
* capital needed for improvements
* pro- forma balance sheet (three years)
* pro- forma income statement (three years)
* pro forma cash flow statement (three years)
* lease or proposed lease terms

2) TERMS OF SALE

· Sales prices
· Method of transfer
· Buyer’s investment and source of funds
· Others financing and terms
· Date of proposed purchase
· Copies of letter on intent or agreement

3) COLLATERAL FOR THE LOAN
· Description and listing of the major business assets
· Acquisition or replacement cost of assets
· Liquidation value of assets
· Insurability of collateral
· Financial statement of guarantors

4) PROPOSED LOAN

· amount of loan
· loan period
· interest
· guarantors to loan
· collateral
· other loan terms
· dates for loan approval

A lender will assess each item following the traditional three C’s of credit:
1) The lender must be satisfied that the applicant is creditworthy.
2) The business has adequate cash flow to repay the loan.
3) The collateral to be pledged will adequately secure the loan.

Some lenders look primarily for strong management, but others are more concerned with stability of earnings. Assets- based lenders rely mostly on collateral. The way lenders prioritize each factor can vary.

All lenders want a successful venture because that is the only way their loan can be repaid. Lenders decline loans when they see fundamental defects in the acquisition or the long-term planning for the business. The lenders opinion on the acquisition is indeed valuable and the lender’s expertise essentially makes him part of the acquisition team.

Finance books discuss the many possible sources of financing. The scarcity of loan sources for small businesses partly explains the popularity of seller financing. It is not that seller financing is always desirable, but rather that it may be the only financing obtainable. And, as many small business buyers have discovered, the only other likely lenders are relatives and friends.

BANKS

As stated, commercial banks are the primary lenders for small business acquisitions. As assets-based lenders, they limit their loans to the liquidation value of the pledge assets. However, more aggressive banks will lens more than the liquidation values of the collateral if the property has a strong record of earnings and proven management. For more speculative loans , the bank also may want a pledge of personal assets, such as a home or securities, and the bank may increase their loan to reflect the value of these personal assets.

Getting the Best Loan Possible

Sometimes a home equity loan is a good way to borrow money, but there are some lenders that only bring problems.

Predatory home mortgage lenders look for people who may have financial difficulty. They hunt for people who may be behind on property taxes, who need to fix up their home, or who need money for medical bills. Once they find these people, the lenders often use high pressure sales talk, high interest rates, outrageous fees, and repayment terms that the person can't afford. Fast talkers can trick homeowners into taking out loans that they can't afford to pay back. When they can't make the payments, their homes are at risk of foreclosure.

Even if you don't have financial troubles, no one wants to pay more than is needed. Why pay interest rates higher than you need to? Why pay unneeded fees or charges? Whether you have excellent credit or not-so good credit, you want the best possible loan you can get.

Don't be fooled by loan offers you see on television or receive in the mail. They don't tell the full story.

Be a smart borrower. Don't get caught in a bad loan!

Follow these steps:

Know your credit rating and credit score.
Sometimes people who have good credit are charged higher rates and fees for loans because they don't know that their credit is good. Getting your credit report and credit score may help you negotiate the best loan for you so you don't pay more than you should have to pay. You'll want to look for any mistakes in your credit report and take steps to correct them. You can get your credit score on the Internet, usually for a fee, or a lender can give you a free copy when you apply for a loan. Avoid lenders who won't give your score to you. Most credit scores range from 300-850, and the higher the score, the better your credit. Most lenders consider scores over 700 as "good" to "excellent" scores.

The three major credit reporting agencies are:

· Equifax: (800) 685-1111, www.equifax.com;
· Experian: (888) 397-3742, www.experian.com/consumer; and
· TransUnion: (800) 916-8800, www.transunion.com/index.jsp.

Be cautious about using a home equity loan to consolidate credit card debts.
Loan offers may tell you how you can save money by paying off credit cards with a home equity loan, but what they don't say is that your home is at risk if you do it. Yes, sometimes this type of loan is useful, but only if the loan's terms are very good-and you won't run up another credit card bill. Even then, if something should happen and you can't make the home equity payment, your home is at risk of foreclosure.

An important difference: Credit card lenders can't foreclose on your home if you don't pay your credit card bills. But, a home equity lender can foreclose if you don't make the mortgage payment.

Shop around.
Get several offers and pick the loan that's best for you-not one that is best for the lender or broker. Use the worksheet on page 11 to help you pick the best loan offer you can get, and

•  Know whether you want a loan or a line of credit.
• Talk to several lenders-not just those who send you mail, call you, or knock on your door. Start with several banks, savings and loans, credit unions, and mortgage companies.
• Understand the role of brokers if you decide to use one. Brokers charge you to find a lender; they don't lend the money themselves. Some lenders also pay the broker and then pass their cost on to you as a higher interest rate. Since you are paying the broker either directly or indirectly, using a broker may not get you the least expensive loan.
• Ask all lenders to explain in detail the loan plan they have for you.
• Pay close attention to the fees. Remember-the loan with the lowest monthly payment might not be the best deal. There could be hidden fees that may cost you more in the end.
• See a housing counselor to discuss your options. You can locate counselors certified by the U.S. Department of Housing and Urban Development (HUD) by calling 1-888-466-3487 or visiting the HUD Web site at http://www.hud.gov/offices/hsg/sfh/hcc/hccprof14.cfm.

Learn about reverse mortgages.
For homeowners age 62 or older, this may be a better option than a home equity loan. These are loans you don't have to pay back as long as you live in your home. With a reverse mortgage you can get a lump sum of money, a monthly income, a credit line, or a combination of payment options.

Close your deal carefully.
Once you've found the loan you want, make sure you get the deal you were promised.

Follow these steps:

• Read the loan papers carefully before you sign.
• Ask a lawyer, housing counselor, or a trusted friend to help you go over the papers.
• Be sure you understand exactly what the lender is offering -and what you're going to have to pay.
• Ask to have all fees explained.
• Ask questions if you don't understand something.
• Take your time. Don't be rushed.
• Be sure that all blank spaces are filled in on all copies before you sign.
• Know your options about credit life insurance. Only buy it if you really need it. Many people don't. If you do want it, shop elsewhere for the best terms. If the lender insists on it, find another lender. Be sure to look for this item on the forms given you at settlement.
• If what you read in the loan is not what you wanted or expected, don't sign the papers! Be prepared to walk out of the settlement (closing) if you find surprises.

Tip:
To Reduce Unwanted Credit Offers call 1-888-567-8688 or 1-800-353-0809 and ask all three credit reporting agencies Equifax, Experian, and TransUnion not to provide information about you to companies wanting to send you loan offers.

Know your legal rights and use them.
You have a legal right to know:

• The total cost of borrowing the money (fees and interest);
• The annual percentage rate (APR);
• The number of payments and the payment amounts;
• How long you have to pay back the loan; and
• The total amount you have borrowed

With home equity loans, you have the right to change your mind, even after you have signed the papers. If you decide within three business days after you sign the papers that you do not want the loan, you have the right to cancel. You can cancel by sending the lender written notice of your decision to cancel by mail, hand delivery, or telegram within three business days. Saturday is a business day. For example, if you sign at 3 PM on Thursday, you have until the end of Monday to cancel. Ask for "return receipt requested" at the post office for proof of when you sent the notice.

Report things that go wrong and get legal help.
If you think that your lender is dishonest-for example, you discover fees that you weren't told about or you were required to buy credit insurance-report it!

• Call your county office of consumer affairs (may be called consumer protection). You can find the phone number in the government listings of the phone book.
• Call your state Attorney General or state office of banking. You can find the phone numbers in the government listings of your phone book.
• Report the problem to the Federal Trade Commission (FTC) at 1-877-FTC-HELP, or at www.ftc.gov.
• Ask a lawyer to look at all of your documents to see if there are state or federal laws that would let you get out of the loan.

Warning Signs
Be cautious if anyone:

• Advertises or says, "Poor credit? No problem!"
• Calls on the phone or comes to your door offering you a "bargain loan."
• Rushes you to sign that day.
• Asks you to pay a fee "up front" to cover a first payment or other expenses.
• Offers you a loan with small monthly payments and a balloon payment that you'll have difficulty paying when it comes due.

If You're Over 61, a Reverse Mortgage May Be a Better Choice for You
A reverse mortgage is a home loan that you do not have to pay back for as long as you live in your home. It can be paid to you in one lump sum, as a regular monthly income, or at the times and in the amounts you want. The loan and interest are repaid only when you sell your home, permanently move away, or die.

Eligible Homeowners

• All homeowners must be at least 62 years old.
• At least one owner must live in the house most of the year.

Eligible Homes

• Single family, one-unit dwelling.
• Two-to-four unit, owner-occupied dwelling.
• Some condominiums, planned unit developments or manufactured homes.
  NOTE: Cooperatives and most mobile homes are not eligible.

How They Work

• Most require no repayment for as long as you live in your home.
• They are repaid in full when the last living borrower dies, sells the home, or permanently moves away.
• Because you make no monthly payments, the amount you owe grows larger over time. By law, you can never owe more than your home's value at the time the loan is repaid.
• You continue to own the home, so you must pay the property taxes, insurance, and repairs. If you fail to pay these, the lender can use the loan to make payments or require you to pay the loan in full.

What You Get and How Much You Get

• Reverse mortgages can be paid to you:
  - All at once in cash;
  - As a monthly income;
  - As a credit line that lets you decide how much you want and when;
  - In any combination of the above.
• The amount you get usually depends on your age, your home's value and location, and the cost of the loan. The greatest amounts typically go to the oldest owners living in the most expensive homes getting loans with the lowest costs.
• Most people get the most money from the Home Equity Conversion Mortgage (HELM), a federally insured program.

Types of Reverse Mortgages

• Loans offered by some states and local governments are generally for specific purposes, such as paying for home repairs or property taxes. These are the lowest cost reverse mortgages.
• Loans offered by some banks and mortgage companies can be used for any purpose.

The Cost of a Reverse Mortgage

• The costs for loans from banks and mortgage companies usually include the following:
  - Application fee
  - Insurance
  - Origination fee
  - Monthly service fee
  - Closing costs
  - Interest
• These costs are usually added to the loan balance (what you owe).
• HECM loans are almost always the least expensive reverse mortgage you can get from a bank or mortgage company, and in many cases are significantly less costly than other reverse mortgages.
• Reverse mortgages are most expensive in the early years of the loan and generally become less costly over time.
• Before getting a reverse mortgage other than a government or HECM loan, carefully consider how much more it will cost you.

What Else You Must Know

The federal government requires you to see a federally-approved reverse mortgage counselor as part of getting a HECM reverse mortgage.

Home Improvements

Your home is worth a lot to you ... but dishonest home contractors see the value in it, too. Every year, people spend billions of dollars for home improvements. Usually the work is done well, but each year many homeowners are victims of poor, overpriced, or never-completed work. Some people posing as home repair specialists are simply con artists looking for easy money. Others are "front men" for predatory lenders.

If you are planning on making repairs or improvements to your home, it is important to pick the right contractor and the right financing. Here's how.

Identify what you want done and how much you can afford.

• Write a detailed description of the work you want done, including the quality of materials, brand names and model numbers you want to be used.
• Know how much you can afford to borrow and repay.

Take time to find a reliable home improvement contractor.

• Get recommendations from friends, family and neighbors.
• Check with the local consumer protection office or Better Business Bureau to see if there are any complaints against the contractor. However, having no complaints filed is no guarantee of reliability.
• Have the contractor prove he is licensed, bonded, and has insurance. Check that information with local government offices.
• Get two or three written estimates that give details about materials, labor charges, and start and finish dates.
• Use the worksheet to help you ask the right questions to compare the bids you get.
• Remember: A clear and detailed contract can protect you if something goes wrong. In general, a contract should spell out who does what, where, when, and for how much.

Don't be pressured to get your financing through a particular company.

• Be cautious of financing offered by the contractor. Dishonest mortgage brokers anc contractors often work together to take advantage of homeowners.
• Get several estimates for the financing, apart from the contractor's estimate.
• Ask a lawyer or housing counselor to explain all the terms of the financing agreement.

Know your legal rights.

• You can cancel the home repair contract by sending a letter within three business days, if the contract was signed in your home or somewhere other than the contractor's permanent place of business.
• You can cancel the financing by sending a letter within three business days, and maybe even later, if your home is used as security for the loan.
• If you think your contractor or lender is fraudulent, notify the police, the local consumer protection agency, your state Attorney General, and state/city office of banking.
• Contact a lawyer. You may be able to sue the contractor or lender using state or federal laws.

Worksheet:

Comparing Home Equity Lenders

This worksheet can help you when you're comparing loans. Ask lenders questions and write down their answers. Remember, it's not only the monthly payment or the interest rate that matters in making your choice. If you compare the at least three lenders for borrowing the same amount, you may find a better deal. See the Glossary below to learn about any terms you don't understand.

Worksheet:
Getting Bids & Selecting a Contractor

This worksheet can help you select a home repair contractor and compare bids. Ask contractors questions and write down their answers. If you compare at least three contractors, you may find a better deal. See the Glossary below to learn about any terms you don't understand.

Glossary

Adjustable Rate Mortgage (ARM): A home loan where the interest rate can go up or down during the time you are repaying the loan.

Annual Percentage Rate (APR): The cost of a loan expressed as a percentage rate. It includes both the interest rate on the loan and many of the costs in getting the loan. APRs are the best way to compare loans.

Balloon Payment: This is the very large payment that is due at the end of some loans. A balloon payment means that the borrower's monthly payments are used to pay the interest on the loan and that little of the payment is used to pay back the amount that was borrowed. Unless you know how you will make this payment, these loans can be risky.

Bid: A written estimate of what your home improvement project will cost.

Closing Costs: All of the "other" costs that you have to pay when borrowing money. They could include fees for credit reports, land survey, appraisal, title search, title insurance, document preparation, notary, points, credit life insurance, and attorney fees.

Credit Insurance: An insurance policy (such as life, disability, or unemployment) that pays the lender the balance of the loan if something happens to the borrower before the loan is paid off. Sometimes the lender adds the entire price of the policy to the amount you are borrowing and this is very expensive because you pay interest on that amount.

Credit Report: Credit bureaus collect information about your credit history-where you owe money, how much you owe, your credit cards, and your payment history. Lenders determine whether to give you a loan and how much to charge you based on information in your credit report.

Credit Score: Your credit score is a number that is used by lenders to decide whether to give you credit and at what cost. It is based on information in your credit report.
Equity: The difference between what your house is worth and what you owe on it. For example, if your house is worth $150,000 and you owe $100,000, your equity is $50,000.

Fraud: Dishonest business practices that lead to your doing something against your best interest.

Housing Counselor: Counselors can help you explore your options, find a loan, and explain loan documents. They also offer help with foreclosure problems. The Department of Housing and Urban Development (HUD) certifies housing counselors.

Installment Payments: Partial payments made to home improvement contractors as the work is being done.

Interest: The percentage rate lenders charge you for using their money. The higher the percentage, the more you pay.

Line of Credit: A pre-approved amount that you can borrow. You only borrow what you need, when you need it.

Mortgage Broker: A person you pay to help you find a lender.

Points: Each point is 1% of the amount you are borrowing.

Predatory Lenders: Lenders who take advantage of borrowers and make loans that the borrowers cannot afford. They may charge very high interest rates or fees, hide costs, or lie about loan terms.

Principal: The amount of money that you borrow.

Reverse Mortgage: A home loan you do not have to pay back for as long as you live in the home. Repayment of the loan is due when the last surviving homeowner dies, sells the home, or permanently moves away.

Settlement: The meeting where you review and sign your loan papers. Also called a "closing."

Total Amount to Repay: This is the total amount of fees, points, and all monthly and balloon payments that you will pay over the life of the loan.