Buying a business in debt

Every business decision carries an element of risk. It's understandable, then, when looking to acquire a new business, some entrepreneurs are less confident about purchasing companies that are already in debt.

For those buyers who may instinctively stay clear of such a purchase, the fact that a business may be distressed or come with outstanding debts should not be a reason to discount it.

With careful planning and research, such expansions can lead to prosperity and financial growth.

Expansion and growth

Plans to expand your business dealings always require mindful considerations over what the future will look like, and whether your current or projected revenue allows for the coverage of operational costs and interest payments on financing. This is especially true when considering making a deal with a debt-laden company.

With a little research into the business you intend to buy and a calculated approach to the process, however, you can ensure future financial performance and learn to take risks that pay off.

In fact, understanding the strategic risks associated with acquiring a new business is the first step towards a successful purchase.

Strategic risk can be divided into financial risk and business risk: financial risk is a company’s ability to manage and leverage debt, while business risk relates to a company’s capacity to generate enough revenue to cover the expenses that are integral to its operation.

Many large corporations have entire teams dedicated to assessing whether the risks involved in financial decisions work to counteract associated business risks. Understanding a company's debt situation and whether or not it will be included in the purchase is an essential prerequisite to buying a business.

Analysis shows that a majority of UK SMEs generally have an average of over £50,000 outstanding from their debtors. Large chunks of these debts, however, are routinely written off.

So it would clearly be wise to make sure you're fully aware of a company's debt situation, and whether or not it will transfer with the sale, before taking any further steps.

It's also worth noting that a company’s debts may not be immediately apparent, so it's up to the buyer to enquire further. To do this, you will be required to sign a confidentiality agreement before obtaining access to this information.

Buying the business

There are several ways to buy a company with debt. You can either acquire a company along with its debts, in which case the seller may set a higher price for the company and settle the debts in the process of the sale, or they will set a lower price and pass all responsibility for them onto the new buyer.

Having a lower upfront purchase price will leave you more capital for the early years of operation – a bonus if you can use this revenue to improve the company's profitability and pay off its debts. If you can't, there's always a risk that the payments associated with the debt you acquired will soak up cash flow and hamper your ability to find additional loans if necessary.

Some sellers will even "split the difference" by settling some of the debt during the sale and passing the rest on to the buyer.

Another option would be for the buyer to purchase the individual loans the company has taken out.

If a business owes money on a loan, the lender can sell that debt to a third party. When that happens, the company buying the loan secures the right to collect that money and even makes a profit off the interest, just like the original owner did. If the buyer purchases the loan in this way, they'll be able to retain complete control of it.

Another type of transaction for an indebted business would be a debt-for-equity swap, whereby the obligations or debts of a company are exchanged for something of value, or 'equity'. In the case of a publicly traded company, this generally entails an exchange of bonds for stock.

The Co-operative Bank went through this process whereby it secured £700m in rescue funding through a debt/equity swap as well as an injection of new equity through hedge funds.

It was still in the red in its fifth consecutive year and was looking at a potential sale.

Investors from the Co-operative Group, the bank's parent company, who are predominantly US investment funds, agreed to write off £443m in debt and buy £250m worth of new shares.

Despite its financial difficulties, the Co-op's almost 4 million customers remained loyal, and although registers recorded an overall loss of £130m at one point, underlying profits jumped to £146m as revenues across the wider group rose three per cent to £9.5bn.

After this impressive recovery, Co-op's core food stores, funeral homes and insurance businesses all gained customers and plans were put in motion to begin exploring other markets including electricity and gas.

Growth and risk often go hand-in-hand in business, and the Co-op is a prime example of a struggling company that was able to be brought back into profitability.

Turning liability into leverage

The key is the ability to take calculated risks.

Paul Russell, director and co-founder at Luxury Academy London, explains, "Business risk often involves change, and change is something that people can shy away from based on the assumption that what is known is safer. But in business nothing stays the same forever, markets change, customer tastes evolve, the economy may falter or soar, and you have to be willing to make changes to survive. And, in most cases this involves some element of risk."

Understanding whether taking on a business in debt or leaving these liabilities behind with an asset sale is right for you is an essential part of the buying process. Debt is common throughout the business world, but shouldn't deter you if all other indicators suggest a profitable return on your investment.

Having a clear idea of the company's corporate life-cycle during the valuation process can provide a reliable indicator of whether the purchase is viable for you, and whether the financial and business risks can be offset.

As long as you calculate all the financial outcomes, taking into account the status of the business and various factors surrounding it, there’s no reason why you can’t expand your business portfolio and profit from a distressed business or one with debt.

Looking for a business to buy? Search businesses for sale

If you want more tips on buying a business in debt, take a look at our other articles:
- How to buy a business out of administration
- Find distressed business opportunities at the right time
- What to watch out for when buying a business

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