How can we make it easier to buy small businesses?

Buy small businesses | bizval Business Valuations

Funding is the structural issue that makes it so much harder to buy (and thus sell) small businesses. The United States Small Business Administration gives us an example of a way to address this.

Small businesses are notoriously difficult to sell and there are many reasons for this. Some of the issues can be addressed, like owner dependency and a general lack of understanding about how to build a business that is attractive to a buyer. Other problems are structural in nature and difficult (but not impossible) to navigate, like availability of funding to buyers.

Of course, if there was more funding out there, then small businesses would be more liquid i.e. easier to sell. This would do wonderful things for the valuations of small businesses, which in turn would promote more of them being built.

We can only dream. Or can we do more than just dream?

Bridging the funding gap

There are many would-be investors in small businesses. Sadly, only a fraction of them have the financial means to pull the trigger, even if they have the ability to make a success out of the business itself. The problem is worse in emerging markets, where risks are higher and capital is harder to find. Developed markets also struggle with this, although we can look to the United States for an interesting example of how activity in small business transactions could be encouraged.

The US Small Business Administration Office of Advocacy conducts research into small businesses and why they are important to the economy. In this article (Small Business Job Creation), they note that two out of every three jobs added to the economy in the past 25 years were by small businesses. In this piece (Small Business Administration Is A Model For How To Drive Economic Growth) in Forbes, the author claims that half of the people who work in America either own or work for small businesses.

It’s impossible to overstate the importance of not just mom-and-pop shops to the economy, but also larger “small” businesses that are meaningful entities in their own right. This is the engine room of the economy. This is Main Street, not Wall Street.

Even the more developed “small” businesses still struggle to find buyers, particularly on commercial terms that achieve a proper exit for the seller. In a structure with a vendor loan, deferred payments or similar, the buyers takes the reins and pays the seller with future profits. That puts all the risk squarely on the seller, which is uncomfortable for obvious reasons and rarely advisable.

For sellers who aren’t desperate, there need to be buyers who have access to capital. Of course, the least desperate sellers often have the best businesses, so this is precisely where buyers should be looking. To get access to capital, buyers need to invite capital partners like private equity and family office investors (the professionals) or even direct family (the rich aunt and uncle) to the table.

The more humans around the table, the more complicated everything becomes. People are very good at having different ideas, which also makes them exceptionally good at turning a happy idea into gross misalignment and a virtual (and sometimes actual) chair-throwing session.

How can more money flow from Wall Street to Main Street without causing misalignment?

The answer is surprisingly simple: debt.

A lender doesn’t want to sift through the quarterly review presentation or come up with pricing ideas for the next product. A lender wants to sit back and earn a yield from a portfolio of investments that has adequate protection in place. These protections take the form of debt covenants, which are promises to run the business within certain pre-agreed ratios and metrics e.g. interest cover ratios.

Easier said than done, of course. Lenders struggle to get their heads around the risks of lending to small business owners, let alone acquirers of small businesses who are taking even more risk on a business they aren’t familiar with. This leads to a complete lack of debt facilities available to small businesses.

Frankly, it’s easier to finance a rapidly depreciating asset like a car than it is to finance a growing business. One has obvious collateral and the other doesn’t. One can be funded based on a set of lending rules and the other can’t.

With bank funding being borderline non-existent in this space, buyers often turn to mezzanine funders. These funders exist, but their structures inevitably come with convertible elements (like preference shares) that make the deal look and smell like equity funding anyway.

In other words, these mezzanine funders often get in the way. If you aren’t careful, they can bring you the worst of both worlds rather than the best.

Clearly, improving the availability of debt is key. How can governments help with this?

Enter the Small Business Administration (SBA)

Simply, the SBA guarantees a portion of loans to make them more palatable to private lenders like banks. The government isn’t lending the money. It is guaranteeing the repayment of the money, or at least a portion of it. To make this viable, the loans must follow strict criteria.

Interestingly, an SBA-backed loan can be used for business acquisitions. The loan amount is up to $5 million and repayment terms are up to 25 years, which is phenomenal. They aren’t cheap, with this article (SBA business acquisition loan) noting rates of between 11.5% and 15%. Despite these rates, lenders wouldn’t be comfortable with the risks involved were it not for the SBA guarantee on the loan. Essentially, the government is stepping in here to reduce credit risk and make it possible for small business buyers (and operators) to get loans by creating a risk-reward opportunity that works for the banks.

Of course, there are many rules involved. For example, it looks like acquisition finance is only available if 100% of the shares in the company are changing hands and if the buyer intends to develop or at least preserve the existence of the business. Another interesting point is that you need to demonstrate that you tried to raise other forms of finance before turning to an SBA-backed loan.

There are many other requirements, including the need for a 10% equity down payment. But overall, it’s still easier to get one of these loans than a traditional bank loan. Think of this as a lender of last resort, with the government trying to promote a market for small businesses to change hands and be preserved or grown.

That last part cannot be stressed enough. The United States government has recognised the importance of the contribution of small businesses to economies. Where far too many governments are out there creating more red tape and bureaucracy for small businesses, some are actively promoting their activities.

The United States promotes small business activities and they make it easier for small businesses to change hands and continue creating jobs. Although it’s certainly more viable to do this in wealthy countries, perhaps more governments should consider this model and how elements of it can be applied in their own countries?