Funding pitfalls to avoid when buying a business
The finer details of funding a business purchase can often be overlooked or put off until the last minute. This is understandable given the time and effort involved in finding the right business. However, it is so important to the future success of the business that buyers must plan ahead.
Many studies have shown that businesses often fail because they end up not having enough capital. According to one recent study, as many as 29% of businesses failed due to lack of capital. Even more alarming, as many as 82% failed after experiencing cash flow problems.
To help first time business buyers avoid this all too frequent outcome, let’s discuss a few common funding pitfalls you should avoid when buying a business.
Insufficient Financial Due Diligence
Fully understanding the financial ins-and-outs of a business is perhaps the most important aspect of the due diligence process. As discussed in the importance of cash flow, knowing how, and how quickly, revenue turns into earnings is critical.
Requesting a business credit report is a good way to supplement your financial due diligence. This report can help uncover any issues the business has had in meeting loan or credit card payments. Any issues could, of course, be due to poor management and not the business itself. But problems here could also point to underlying business issues like collecting receivables or other cash flow weaknesses.
Proper financial due diligence not only can help you avoid a poor investment, it ultimately can help fund the purchase itself. When applying for an SBA-backed bank loan, the better you can articulate your understanding of the financial aspects of the business, the better your chances of receiving funding on attractive terms.
Underestimating Future Funding Needs
New business owners will often underestimate the amount of capital investment a business will need. Most businesses will need more employees, office space, investments in equipment, or other capital investments to grow. When conducting your due diligence, it is wise to be skeptical of any growth or forecasts that include large growth without any capital investment.
Expecting the unexpected and planning ahead can help make sure your business survives during downturns. To make sure you are well prepared, spend time understanding these sometimes-overlooked budgeting items:
- Capital improvements to office and store locations
- Repairs and replacement of vehicles, equipment or technology
- Marketing needs to achieve growth plans
- Additional payroll and employee related expenses
- Working capital needs
Make sure to have a well-thought-out plan in place before applying for a loan. Lenders will often be more willing to lend on attractive terms when the business is doing well. If you wait until cash flow issues arise and you are desperate for capital, banks will be more reluctant to lend.
Not Focused on Personal Credit
Even when buying an established business, lenders will focus on a buyer’s personal credit. To avoid any surprises, know your personal credit score. Free services like Credit Karma make it easy to monitor and find ways to improve your credit score.
A few quick tips offered by Fair Isaac Corporation, whose FICO Score is used by most lenders:
- Set up payment reminders to make sure you pay your bills on time. Payment history counts 35% toward the FICO Score and one missed payment can have a big impact.
- Reduce the amount of debt that you owe. Credit utilization counts 30% toward the FICO Score so repay outstanding balances as quick as possible.
- If looking for a new loan, do it all at once. The FICO Score distinguishes between searching for a single loan and searching for many different lines of credit, which can be harmful if done in a short period of time.
If your credit score could use some improvement, start taking steps today before applying for a loan. It can often take several months for positive changes to be fully reflected in the score.
Informal with Friends & Family
Lenders typically look for several years of strong financial results to support their lending decisions. Therefore, it can be difficult for early stage companies or companies going through a downturn to get bank lending. Because of this, many new business buyers and entrepreneurs will raise money from friends and family. In fact, this is one of the most common ways early-stage company’s raise capital.
While it can feel informal going to friends and family to request funding for your business, you should treat the business investment as just that – a business arrangement. That means treating the relationship in a formal manner like you would with any third-party lender or investor. It is a best practice to present a business plan outlining your goals for the business. You should also look to establish a plan for regular communication about the business’ progress.
Also, make sure the relationship is captured in writing and clearly outlines the type of investment.
Important points include the percent ownership they will receive, voting power, as well as any rights or restrictions on sales or future investments. This approach will make them a business partner, so you will likely want a lawyer involved to help draft the agreement.
Be sure to include the interest rate, repayment schedule, and any other relevant terms. Given the more defined schedule of repayment and return of the investment, loans tend to be a more common form of funding for friends and family.
Don’t forget to ask experienced advisors for help if you have questions. Talk to a lender before applying for a loan or seek out advice from an accountant or industry experts. Plan ahead and avoid the common funding mistakes above and you’ll be well on your way to setting up your new business for success.
DISCLAIMER: The information contained in this article is for informational and discussion purposes only, and should not be relied upon without seeking your own professional advice. The Firm Exchange, LLC is not a law firm, accounting firm or professional services firm, and accordingly it disclaims any liability for any reliance on the contents of this article. As each situation is unique, you are encouraged to discuss your specific situation with a qualified attorney, accountant and/or other relevant professional services provider.