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Differences Between Financing a Startup vs. a Newly Acquired Business

Filed under Financing a Startup. Fact checked on May 24, 2012.

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Startup businesses often begin with only ideas and enthusiasm. One of the many issues that every entrepreneur must address when starting a small business is the financial reality involved in deciding exactly what he or she wants to do, when it can be done, and how it's going to be done.

New small businesses have trouble securing conventional financing because they present a tremendous risk to lenders and investors. The result is that nearly three-quarters of startup businesses are funded through the owner's own resources, such as personal savings, residential mortgages, or consumer loans. Family members, friends, and investments by private contacts or "angels" provide most of the remaining "seed" funds for new small businesses.

The cash crunch. The most common financial problem for startup businesses is a shortage of short-term cash, and cash flow problems during a potentially long initial period can be fatal to the business. Any debt financing (loans) that the business can secure from traditional lenders is likely to be expensive because of the high risks assumed by the financier. Moreover, unless the business can boast a significant owner investment and marketable collateral, the availability of conventional debt financing is almost nonexistent.

This cash crunch puts a tremendous focus upon inventory turnover, and the need for immediate revenue often becomes a daily crisis that takes priority over financing for sustained growth or development of new products. Perseverance and a willingness to investigate all sources of financing — from angels to government loan programs — are invaluable at this stage.

Warning

The financial pressures of a cash flow shortage has forced many small business owners to take unwise, desperate measures to salvage their business. For example, cash-strapped entrepreneurs may try to "borrow against" payments of quarterly payroll taxes, hoping to repay delinquent amounts as soon as business improves. Unfortunately, the problem is rarely resolved and the entrepreneur not only ends up with a failed business but personal and potentially criminal tax liability for failure to submit payroll taxes.

For a complete discussion of the issues involved in beginning a new enterprise, see our discussion of starting your business.

Financing Acquired Businesses

In many respects, the financing options available when you purchase an existing business are similar to the options for raising capital in a growing business that you already own. Debt and equity vehicles are typically more available to you than if you were starting a similar business from scratch. Because the target business has a credit history, existing assets, an established operating cycle and business goodwill, lenders and investors can be approached in the same manner as if you were seeking to expand a business you already owned.

Warning

You will find that some small business advisors may advocate borrowing as much money as you can get, regardless of how much money you think you are going to need for a particular purpose. They assume that it will be easier for your business to manage debt (once you have cash) than it will be for your business to obtain cash when it's really needed. 

However, while this advice may sound savvy, the reality is that most of your small business debt will also be your personal debt, and any default may mean disaster to your personal finances. Moreover, the more debt you assume, the harder it may be to obtain additional funding, on much better terms, when you are in a better financial position to obtain it. In short, advocating a limitless assumption of risk and debt is easy when it's not your life savings, your house, or your family's assets on the line.

The major distinction between financing for the purchase of an existing business and financing to raise funds for your own growing business is that the former offers the opportunity for seller-financing. Entrepreneurs who are selling their small businesses usually realize that they may need to participate in the buyer's financing of the business sale, and they may be willing to negotiate a very favorable debt or equity arrangement with you.

Potential advantages to seller-assisted financing.

  • You may get a reasonable interest rate and a less demanding credit review.
  • The existing assets of the business are often the exclusive collateral for the financing. In contrast to the common practice of conventional lenders, additional or personal assets of the buyer are rarely pledged as additional collateral on a seller-financed loan. Moreover, a seller's valuation of the business's assets (collateral) tends to be higher than that of a conventional lender; a low valuation might appear inconsistent with the asking price for the business.
  • Personal guarantees are less likely.
  • A seller may be willing to take a subordinate (secondary) security interest. The seller may be amenable to taking a subordinate interest to allow you to obtain conventional financing. The incentive for the seller is that the more money you can obtain from other sources, the more money the seller gets upfront. A conventional lender will require a priority claim on business assets and so the only way you may be able to qualify for the loan is to subordinate other creditor claims.
  • The buyer's assumption of the existing debts or liabilities of the business may be a means of reducing the purchase price. Typically, much of the downpayment or initial cash price of a business sale goes toward a reduction of existing business debt. However, rather than pay off existing creditors, those debts may be assumable by the buyer in exchange for a set-off on the purchase price of the business. The business creditors essentially become financiers for the acquisition.
  • A gradual buyout may be acceptable to the seller. For instance, the business name and goodwill, and perhaps some tangible assets, could be sold upfront; other equipment or property could be leased by the buyer with a optional or mandatory buyout at a future time. The seller may be willing to accept an earnout arrangement, where a portion of the purchase price is dependent on the future success of the business.
Work Smart

As a seller, the biggest obstacle to a buyer's assumption of business debts is that the seller may remain personally liable on those debts. If the seller signed the contracts in his or her own name, committed to personal guarantees, or operated in a business form that created personal liability (e.g., sole proprietorship or partnership), the seller cannot escape these liabilities merely by selling the business; the seller remains personally responsible on the preexisting debts. Unless the creditors agreed to a subordination contract — in which the creditor agrees to substitute the new owner or entity for the former owner — the seller is unlikely to allow a buyer's assumption of debt to reduce the business's purchase price if the seller remains personally liable for a large amount of debt.

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