Financing a custom software development shop acquisition

A custom software shop’s worth sits largely in its people, which affects what there is to finance against. There may be little equipment to repossess, no inventory, and, unless the shop built products of its own, little intellectual property that it owns outright. What a lender has to look at instead is a stream of billings, a set of contracts and a team. BDC describes its business purchase or transfer loan as repaid based on the borrower’s cash flow, and the Canada Small Business Financing Program requires security over business assets for loans of certain kinds, as set out below.

What can be offered as security

A general security agreement gives the lender a charge over the borrower’s assets, and in Ontario a security interest in personal property can be perfected by registration under the Personal Property Security Act. The Canada Small Business Financing Program guidelines give accounts receivable, inventory, equipment, real property, investments and liquidities as examples of business assets that can be taken as security. For a development shop that may mean receivables, cash, equipment and any software or tooling the shop owns. That last item connects to diligence. A lender can only take security over what the shop actually owns, so a missing copyright assignment can also reduce the collateral, and a lender may ask to see the same chain-of-title documents the buyer’s lawyer is reviewing. Other provinces use their own statutes and registers for security over personal property, so the mechanics depend on where the shop is located.

How public programs treat a purchase like this

Two channels are worth understanding as structures, not as offers. The Canada Small Business Financing Program works through lenders, and its published guidelines are specific. Goodwill counts as an intangible asset when it is part of a going concern purchase, and a term loan can finance intangible assets and working capital costs, but only within a capped portion of the program’s loan limits. Where a loan finances software, intangible assets or working capital costs, the lender must take security over any assets of the small business. The guidelines also say that the acquisition of shares is not eligible for financing, and that vendor take-back financing is not eligible for a program loan. They say the purchase and sale agreement for a going concern should allocate the price among the assets, that without it other documents setting out the allocation (such as the purchaser’s financial statements or an election filed with the CRA) may be sufficient, and that a value set out in an appraisal will not be accepted as the allocation. Where much of a shop’s price is goodwill, how the price is allocated, and whether the deal is a purchase of assets rather than shares, shapes whether this program can be used at all. The current limits are on the program’s pages.

The Business Development Bank of Canada describes its business purchase or transfer loan as repaid based on cash flow, with extra financing available for intellectual property, goodwill and client list. It says financing may combine a business purchase loan, cash flow financing or mezzanine financing depending on the size and structure of the deal. It reviews a request once a business has been identified and the main terms negotiated, and it looks for an agreed purchase price and a clear transaction structure.

What to have ready for a lender

• Recast earnings and the workings behind them, so that a lender can see what the shop earns after a market wage for every role the owner fills.
• Revenue by client over several years, with the contracts behind the largest ones and their termination rights.
• The signed backlog, and how much of it is covered by commitments the client cannot cancel on short notice.
• The chain of copyright assignments for any software the shop owns, since that software may form part of the collateral.
• Evidence that senior developers will stay, and the buyer’s plan if one leaves.
• The buyer’s own equity and personal financial position and, where the lender asks for it, a personal guarantee.

Where seller financing and earn-outs sit

Seller financing and earn-outs keep the seller involved after closing. The BDC points to vendor financing, an earn-out and a phased transfer of ownership as ways a seller stays involved after the sale. An earn-out ties part of the price to what the shop earns afterward, which can suit a business whose backlog may or may not convert once the owner leaves, while vendor financing is a loan from the seller. Where a seller’s note ranks against the bank’s loan is a term to settle with the lender and write into the loan documents, so ask the lender early what it requires. Remember the program point above: a vendor take-back portion cannot be financed under a program loan, so the cash from the lender and the portion carried by the seller have to be sized together. For the mechanics of an earn-out, see earn-outs explained.

Working capital needs funding too

A shop pays its developers each pay period but is paid when clients settle their invoices, which may follow milestones. Between the two there can be a gap, and a buyer who spends all the borrowed money on the price may have little left to fund payroll until the first invoices clear. The Canada Small Business Financing Program guidelines allow a line of credit to finance working capital costs, which a term loan can also cover, and the BDC lists a working capital loan among its products. Whether a lender will fund the gap, and on what security, is a question to raise in the first conversation. See working capital in a business sale.