How to finance a business acquisition and cut risk: seller finance, loans and earn-outs

Buying a business involves a lot of risk. Key employees might leave, important clients might stop doing business with the company you have just bought, and you can lose money, time and reputation as a result. The question is how to finance an acquisition without putting your own money in and without carrying all of that risk yourself. There are three parts to the answer: seller financing structured so you avoid a personal guarantee, loans secured against the target business rather than against you, and earn-out provisions that tie part of the price to the business staying profitable after you own it.

Seller financing (vendor loan) explained

Seller financing, in short, is when you do not pay all of the money on completion. Instead, you pay some of the purchase price after you have already bought the business. For example, you might pay 70% of the purchase price after completion, and that 70% is recognised as a loan the seller is giving to you.

It is the first and, in my view, the most important tool for reducing your risk, because the seller is left with a direct financial interest in the business continuing to perform.

Avoid personal guarantees when buying a business

If you use seller financing, make sure you do not fall victim to what I call the personal guarantee vortex. That is where you use several different financing options, seller financing but also invoice financing and others, and you end up signing a pile of personal guarantees to the various lenders. Each one on its own looks manageable. Together they put everything you own behind the deal, which defeats the point of financing it without your own money.

Floating charge instead of a personal guarantee

Here is how one of my clients obtained seller financing without signing a personal guarantee. He was buying a business through a share purchase and wanted to defer about 70% of the purchase price until after completion, with that 70% treated as seller financing. He was buying through a special purpose vehicle: a newly incorporated limited company whose sole purpose was to hold the shares in the target.

Put yourself in the seller's shoes. You are being asked to sell the company you spent years building to an SPV. That SPV is the one that will owe you the deferred amount, and it holds no assets. That is a huge risk for the seller, so, as you would expect, the seller asked my client to sign a personal guarantee covering the SPV's obligation to pay.

I did not want my client to give a personal guarantee. Instead, I suggested that the seller take security over the target business itself, in the form of a floating charge. The seller eventually accepted. The result was that my client did not have to sign a personal guarantee, and the seller was still able to secure the deferred price against a real asset. Both sides got what they actually needed.

Business secured loans for acquisitions

The second way to minimise your risk is, again, about financing, but this time the loans are secured against the target business rather than taken out personally. Building on the example above, if 70% of the price is seller financed, what about the first 30% payable on completion? We do not want to use our own money for that either. This is where what I call business secured loans come in. There are three main kinds: asset leveraged finance, invoice finance and cash flow finance.

Asset leveraged finance explained

Asset leveraged finance works much like a mortgage on your home: you take out a loan and that loan is secured against a real asset. In an acquisition the asset can be property or premises, but also plant and machinery.

This kind of loan works best when you are buying a business that has a lot of assets, such as stock, premises or important machinery. It does not work well if you are buying a service-based business that has no premises and operates online, because there is nothing for the lender to take security over.

Invoice finance for buying a business

Invoice finance is when you secure a loan against the debtors of the target business. Say the target has invoices due to be paid to it totalling £100,000. An invoice financing company may give you a loan against those invoices.

This works best for a target business that delivers its services or products before getting paid, so that it always has invoices outstanding. It does not work for a business that takes payment up front, such as an e-commerce website where the customer pays first and the product is delivered later. For the right kind of business, invoice finance is a genuinely good way to fund part of the purchase price.

Invoice finance risks: a cautionary tale

One of my clients was using invoice financing to cover 100% of the initial payment due on completion, the 30% in our example. When completion day arrived, it turned out that some of the target's invoices had already been paid, so the amount of outstanding debtors had fallen. The invoice financing company could therefore lend less, because there were fewer assets to secure against. The reduced amount was not enough to meet the 30% completion payment.

Completion had to be delayed by a few days while the target business raised more invoices, so that enough finance became available to meet the initial payment. The moral of the story: do not use invoice financing for the entire completion payment if the amount of debtors and the completion payment are close to each other. Leave headroom.

Cash flow finance explained

Cash flow financing is when a lender gives you a loan based on how much cash flow the target business generates, usually in a predictable way. It works best for a target with recurring, predictable revenue: a tech business with subscriptions, for instance, or an accountancy practice with retainers. It does not work well for a sporadic business, such as a consultancy that takes on projects on an ad hoc basis, because the lender cannot rely on the income.

Earn-outs as acquisition finance

The third part of minimising your risk is about making sure the business stays profitable after you have bought it, and the tool for that is the earn-out. Earn-out provisions apply where part of the purchase price is payable after completion, the 70% in our example, and that deferred amount is adjusted according to how much profit the target generates. If the company generates more profit than the target profit, the seller is paid more. If it generates less, the seller is paid less.

How earn-outs work: a worked example

Picture a graph. On the vertical axis is the profit the target has generated; on the horizontal axis are the years after completion: one, two and three. A red line marks the target profit the buyer and seller have agreed as the benchmark. A green line shows what the company actually made.

• Year one: the company generates £50,000 less than the target profit.
• Year two: the company generates exactly the target profit.
• Year three: the company generates £60,000 more than the target profit.

If the earn-out is pound for pound, so that each pound above the target means one more pound for the seller, the calculation is simple: deduct £50,000 for year one, add nothing for year two, add £60,000 for year three. The net effect is £10,000 added to the purchase price and to what the seller receives. Had the business underperformed throughout, the price would have come down, and that is the protection the buyer is paying for.

Earn-outs: balancing buyer and seller interests

Keep in mind that in an earn-out the buyer and seller have competing interests. The buyer will typically want to hold back short-term profit in favour of long-term gains. The seller will want to maximise short-term profit so that they receive more under the deal. A seller is also unlikely to agree to earn-out provisions unless they retain some control over the business after they have sold it to you, because their money depends on how it is run. Both of those tensions need to be addressed in the negotiation and in the drafting.

Next steps

Before you make an offer, map out how the completion payment and the deferred payment will each be funded, which security you are prepared to give and, just as importantly, which you are not. Identify the risks in the target through due diligence first, since that is what tells you how much protection you need. Then speak to a corporate solicitor with acquisition experience, so the seller financing, any charges over the target and the earn-out mechanism are structured and documented to keep the risk where it belongs.