Coming up with ideas for startups is easy. Finding the capital to get those ideas off the ground is hard — really hard. I know this from experience. One of my startups never reached its funding goal at all, and it took more than a year to find adequate funding for another.
Startup capital is so elusive because investors have to be cautious. According to a Wall Street Journal article by a Harvard Business School faculty member, as many as 75% of startups backed by venture capital fail. So it’s not surprising that venture capitalists only fund around 1,500 startups a year and evaluate 400 companies for every one they invest in. The venture capital business model is one of portfolio theory, and it favors the venture capitalists, not the entrepreneur. This is because all startups are speculative and uncertain to some degree.
Established businesses, however, don’t face that challenge. They’ve proven their concept, built their brand, and solidified their infrastructure. Unlike the 42% of startups that fail because of poor product-market fit, these businesses have demonstrated their purpose and reason to exist.
For this reason, they are especially appealing to investors looking for safer bets. Acquisition entrepreneurship is a bankable approach because it’s based on a business’s historical earnings.
Capital Sources for Entrepreneurial Acquisitions
Investors can raise more capital for entrepreneurial acquisitions. Here are three sources they can use:
1. The Small Business Administration
The SBA recently made changes to its loan policy explicitly designed to help acquisition entrepreneurs. Buyers previously had to put up at least 20% equity, but they can now put up just 10% and finance 90% of their deal. The loans are capped at $5 million, but most acquisition opportunities fall below that threshold, so it doesn’t present an issue. When they need more than that, SBA loans can cover at least a big part of the purchase price along with other financing options.
Investors should keep in mind that these loans require a personal guarantee, meaning the entrepreneur carries responsibility. If the business fails, the debt is entirely on the entrepreneur. And because rates are adjustable, there is a risk of higher payments during the12-year amortization period. Further, any loan defaults could entitle the SBA to seize collateral from the business, which can often be the business itself.
Despite these risks, SBA loans are an appealing option, largely because of their accessibility. In April 2019, big banks approved 27.5% of small business loans, while small banks approved a significant 49.8%, according to the Biz2Credit Small Business Lending Index — both higher figures than the previous month. Easy access to capital is just one reason entrepreneurs report being more optimistic than they have been in 45 years, according to the NFIB Small Business Optimism Index.
If this option seems viable and like the path you want to pursue, make sure to get SBA-approved. This gives investors a signal that you’re a good buyer and makes them more likely to give you access to the capital you need.
2. Traditional Bank Loan
Startups struggle to get traditional bank loans because they have no revenue to report or infrastructure to collateralize. Most banks won’t even consider these borrowers, so they have to rely on venture capital or angel investors.
Established businesses, however, can prove their performance in ways that make banks confident enough to extend them traditional loans. In fact, it’s not uncommon to be underwritten in four to six weeks when taking this route. If the business has sufficient hard assets to back the loan — a factory full of manufacturing equipment, for example — this traditional form of loans is the fastest source of capital available. Bank loans also have the advantage of fixed interest rates, which works well for most and only works against the rare investors who pay their principal down early.
Banks base their loan decisions on the strength of the business and the borrower’s credit. When both are good, they’ll actually compete with each other to loan the money. You’ll typically be advised to visit three to five banks to get a variety of loan offers, so it’s important to be sure not to grant the right of first refusal before identifying your top one or two options.
3. Search Fund
Search funds are comprised of financial contributions from parents, alumni, and investors. The funds provide compensation to an acquisition entrepreneur and cover the purchase price, leaving the investor around 20% equity and splitting the rest among fund participants.
The number of active search funds has never been higher. In 2017 alone, search funds purchased a record 17 companies, according to the Stanford Graduate School of Business. Their popularity is growing, and activity is picking up because they benefit everyone involved. They allow investors to scale the amount of liquid cash they have access to, meaning they can strive for a business valued at $20 million instead of $2 million. The liability is also less because there is no personal guarantee required of the entrepreneur. In general, search funds make finding, buying, and even closing a business easier because more parties are involved.
Unfortunately, this option isn’t easily attainable. Typically, only the top MBAs can earn the trust of search fund investors. It can be difficult to raise actual funds (as opposed to fund commitments), too. And the biggest downside is that the investor only gets a portion of the equity instead of equity in its entirety.
Investors attracted to this model have reason to be optimistic, though. According to Generational Equity, 12 million Baby Boomers own businesses. And many of them will sell soon considering that 10,000 of them reach retirement age every day. Because of this, a projected $10 trillion in assets will transfer ownership, creating a number of opportunities for search funds. They will continue to attract eager participants, as they delivered an aggregate return on investment of 6.9 times in a Stanford Graduate School of Business study.
DISCLAIMER: This article was written by a third party contributor and does not reflect the opinion of Born2Invest, its management, staff or its associates. Please review our disclaimer for more information.
This article may include forward-looking statements. These forward-looking statements generally are identified by the words “believe,” “project,” “estimate,” “become,” “plan,” “will,” and similar expressions. These forward-looking statements involve known and unknown risks as well as uncertainties, including those discussed in the following cautionary statements and elsewhere in this article and on this site. Although the Company may believe that its expectations are based on reasonable assumptions, the actual results that the Company may achieve may differ materially from any forward-looking statements, which reflect the opinions of the management of the Company only as of the date hereof. Additionally, please make sure to read these important disclosures.
Walker Deibel is an acquisition entrepreneur who has co-founded three startups and acquired seven companies. Walker is passionate about helping entrepreneurs avoid the startup killers through buying an existing company rather than starting from scratch. His new book, “Buy Then Build,” is your guide to outsmart the startup game, live the entrepreneurial lifestyle, and reap the financial rewards of ownership now.
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