Ep. 3 - Funding Small Businesses: How Bank Financing Really Works

Assuming your ambition alone can secure a multi-million dollar commercial loan is a fast track to a collapsed deal. Navigating the world of small business acquisitions requires an early reality check because a bank does not fund your dreams or your enthusiasm. We sit down with Megan Lahay, Vice President and Commercial Relationship Manager at Encore Bank, to break down how lenders actually look at transactional risk and what it takes to get a deal across the finish line.

We get into the technical realities of structuring debt and how lenders conduct a dual evaluation of both the operator and the commercial entity. Megan Lahay explains the vital importance of maintaining a healthy debt coverage ratio, how banks approach common adbacks like depreciation and interest, and why operational continuity must be secured in the asset purchase agreement. We also dive into how a buyer's personal financial strength and industry-specific management experience can ultimately make or break the underwriting process.

The truth of the matter is that a great business cannot fix a bad operator, and a great operator cannot rescue a structurally broken business. Lenders look for predictability, meaning that incomplete tax returns or company-prepared financial statements that have not been vetted by a certified CPA will stall a transaction instantly. You will walk away from this conversation with a clear framework for how to position an acquisition for success, clean up your accounting records, and leverage early banking relationships to offer transactional options rather than solving late-stage problems.

If you care about small business acquisitions, commercial lending structures, and building predictable business value, you’ll get a lot from this episode. Please make sure to subscribe to the channel and share this video with a fellow entrepreneur. What is the most challenging financial hurdle or bookkeeping lesson you have had to navigate when preparing a business for a major transition? Let us know in the comments below.

Transcript

SPEAKER_00 0:00

This podcast is for informational purposes only and does not constitute legal, tax, or financial advice. Always consult with your professional advisors before making any business or investment decisions. If you're thinking about what's next for your business, remember the best outcomes are built well before a deal ever happens. Welcome to Owner to Owner, the podcast where Northwest Arkansas business owners learn how to build value, prepare for transition, and understand how deals actually get done. This podcast is sponsored in part by TransWorld Business Advisors of Northwest Arkansas. Your business may be worth more than you think. At TransWorld, we help you prepare, value, and sell your business the right way. Visit TWorld.com forward slash NW Arkansas. Today, my guest is Megan Leahy. Megan is the vice president of commercial relationship manager at Encore Bank. And I might note, she is also recognized as one of Northwest Arkansas's 40 under 40 in 2025. Congratulations, Megan.

SPEAKER_01 1:05

Yes, thank you so much, Cam, for having me.

SPEAKER_00 1:07

Yeah. So let me tell you a little bit about Encore before we start. Encore Bank is a private boutique bank with a commercial business focus that couples highly experienced and talented bankers with innovative technology to offer unprecedented levels of personal service and experiences to its clients through a hospitality-inspired concierge approach. And I can speak to this personally because Megan is actually my concierge banker. Yeah. I really like the process. We, we, we uh at TransWorld Bank with Encore. Uh Encore provides a full suite of financial products and services to businesses, business owners, professionals, their families, and contacts with purpose, passion, and precision. Megan, welcome. Yes. Great to have you here.

SPEAKER_01 1:50

So much. Thanks for having me. This is exciting.

SPEAKER_00 1:52

So our episode uh topic today is how bank financing really works in a small business acquisition. Financing is not just a buyer issue, as we both know. It affects value, structure, timing, and whether the deal even closes. Right. So without further ado, we'll hop right in. Um, first question for you is when should a banker even enter into the acquisition process?

SPEAKER_01 2:15

Yes. Um, the buyer honestly should enter into the process the sooner the better. Um, sometimes buyers wait until they're deep in the trenches with doing due diligence with a seller or with a broker. Um, but bringing in a banker in the early stages can really help alleviate a lot of headaches and a lot of time. Um, when we're evaluating a client of business, we're usually looking at two separate things. We're looking at the client itself and then the business itself. At the client level, we're looking to see if you have the experience and know-how to operate the business that you're wanting to purchase. Example, a restaurant. You come to me, you say, Megan, I want to buy this restaurant. My first question is going to be have you ever owned a restaurant? Have you ever operated a restaurant? Have you managed people in a food and beverage industry? Those are things that are really important. Um, the sooner I understand that piece of it, I can also see how you're going to be operating and how the business that you're seeking to buy will succeed with you as the operator. Um, so understanding both and the is key. And then the faster that I can see those key factors with an operator and with a business, I can tell you whether the deal is financeable or not, stable, what structure will work with you, what structure will work for the bank. Um, I like to say that the earlier we see a deal, we're usually offering options, but the later we see a deal, we're usually trying to solve problems.

SPEAKER_00 3:35

Yeah, yeah. You know, and it's often that we encounter buyers that have a lot of ambition. They're excited, and you know, maybe they've got a little bit of cash in their pocket. Maybe they're coming out of, you know, corporate America or something, and they're like, I'm gonna go buy a business. I'm gonna be a business tycoon, but they don't actually understand how it works. Yes. Seems like the earlier they start talking to um a bank, the a lender, then the more realistic they get on what they can really afford to buy to off.

SPEAKER_01 4:03

Oh, yes. People have high dreams, high aspirations, and I'm definitely not here to squash those dreams at all. I'm just here to help provide realistic expectations.

SPEAKER_00 4:12

Yeah. And um, you know, I think getting the buyers to understand that earlier in the process also helps us not waste a bunch of time. Yes. Um it's uh it it's not uncommon at all for a buyer to think, oh, well, I can afford uh a loan like this. And what they don't even realize is that there's options on the table for them to look at on the way a deal is structured. They can actually make it look uh much more attractive to a bank to want to lend it. We'll talk a little bit more about that later. But um, there's a lot of options and a lot, you know, it's not just like you're going to get a car loan. This is a business. There's there's a little bit more to it.

SPEAKER_01 4:48

Oh, yes, there are for sure options. You know, we offer everything from in-house commercial lending, but then we also partner with on small business administration loans. Yeah. And those can range from the 7A loans, the 504 loans. So there are definitely lots of options that we can help try to not have to force a situation, but make it work best for the client, but then also for us at the bank level.

SPEAKER_00 5:08

Yeah. And you know, another thing for um for buyers to know is the more you know about the bank you're trying to work with, the more you'll find out what those options are. And as a business broker, one of the things that's been most helpful to me is to develop that relationship with the bank because I can actually go in advance as well and and have the bank look at the deal separate from the the buyer. And we'll talk more about that a little bit in a little bit as well. But um, really getting the the bank involved early on, it's like they have tons of experience doing this. And all of that experience can bring to bear the the best option for your for your deal.

SPEAKER_01 5:45

No, for sure. Pre-vetting a business would be a great tool for any seller to engage with. Yeah. Um, because it gives kind of, and like you said, we'll talk about that more, but it'll definitely give them a leg up when trying to get their business sold if that's the decision they've made.

SPEAKER_00 6:00

Yeah, yeah. So when a buyer brings you a potential acquisition, how do you evaluate the buyer versus the business being purchased?

SPEAKER_01 6:07

Yes. So when I first look at a client of business that we are that they're seeking to purchase, you know, I'm looking at the whole picture. First off, evaluating the buyer client, like I said earlier, uh, to see what relevant industry they have, what management experience they have in that sector of business. Um, we're also looking at their personal financial strength. Um, are they going to be capable of paying back a debt to this business if the business doesn't succeed after the transition? Um, are they going to be able to pay back that debt themselves personally? Um, looking at their liquidity to make sure they have enough for a down payment, post-closing reserves to make sure that after the transition, you know, no bills are being not paid. They're able to service the debt of the loan, they're able to pay their employees of that company. Um, all of that's very important for us to look at. Do they have a realistic operating plan? Um, projections for when they take over. Typically, we want to see at least a three to a five-year projection. And those are projections based on realistic numbers of where they intend to take the business once they take over ownership. What changes they're going to, what are they going to be implementing to grow and to continue being successful in that business? All of those are very important that we look at for the client or the potential buyer. All those details matter. Uh, from the standpoint of evaluating the business, you know, I'm looking at historical cash flows to ensure the business isn't in financial disarray. Um are revenues growing year after year. I always like to say bankers like to see trends going up and to the right. Um so we're looking for that on their historical cash flows. Are the tax returns up to date? I can't tell you how many times we um engage with a business owner and they don't have tax returns accessible from a few years ago. Well, why not? Yeah. Um, those are all kind of red flags to a lender, a banker that we're looking at. So having year-to-date financials up to date and clean is the purchase price of the business relevant to the revenues? Yeah. Um also looking at their clientele. That's another important factor because if they have one to two, you know, very strong clients making up 40 or 50% of their revenues, what happens if those clients leave after the transition of ownership? Yeah. Um, there's a lot of things that we really dig into and look at. We're not just looking at just the client or just the business, but the whole picture together. Um, because my job is just to make sure that the business can support the debt and that the buyer can keep cash flows going strongly if the business doesn't succeed.

SPEAKER_00 8:37

You know, the key takeaway for me in all of that is it's not just the buyer and it's not just the business. Right. Both have to match each other. So for instance, you could have a very wealthy buyer that has no problem, you know, great credit rating, can get a loan for probably even more than they need for this business. Yes. But the business is tanking and they have no experience in this, in this um industry. Now, if they were really experienced in the industry and maybe they weren't as wealthy, it might be a better fit for them. But just having money and a good credit rating doesn't mean you're going to be a good fit for that business. And just because it's a great business doesn't mean that you're qualified to run it.

SPEAKER_01 9:19

Yes.

SPEAKER_00 9:19

That's that's what I hear.

SPEAKER_01 9:21

Yeah, I heard a I heard a quote and I actually wrote it down here. I can't remember who said it, but it was a great business can't fix a bad operator, and a great operator can't fix a broken business. And I believe that's true. I love that. Um you have to have both working cohesively to be successful.

SPEAKER_00 9:37

Yeah, that is that is a really, really good, good takeaway. Um, so what makes an acquisition bankable from a lender's perspective?

SPEAKER_01 9:45

Oh, you know, us bankers, we love to mitigate risk. Um, to me, in my opinion, bankable means predictable. So predictable cash flows, predictable operations, predictable transfer of ownership, a bank's evaluating risk, and with risk comes unpredictability, and we don't like that. So we want to see as little risk as possible, um, strong, stabilized cash flow, quality earnings, retention of the staff that are going to be remaining when the transition occurs for the business, um, buyer injection, the down payment, clean, well-structured purchase agreements, all of those are items that we look at. I don't think, you know, bankability is magic. Um, it's math management and then clean, concise structure.

SPEAKER_00 10:28

Yeah. I mean, that's that's a fabulous, concise way to put it. Um and, you know, when I think about it, I also think about the fact that um you can structure a deal multiple different ways, right? So one of the things that we like small business owners who are selling a business to think about is whether or not they should consider seller financing. It lowers the size of the note that um a buyer might be getting from the bank. Now, the bank is still going to look at the total deal structure and look at the total debt service coverage ratio. Those are that's one of those terms I learned about getting into this business is banks really want to know that the the business has the ability to create enough cash flow to cover all of the debt and who gets paid first if things start to get short. Those are things banks look for, right?

SPEAKER_01 11:18

Yes, 100%. Um, a lot of times deals do come across my desk with the owner financing piece. Um, we just have to ensure at the bank level that we are in first position. And then, like you said, that the cohesive debt coverage ratio, DCR, um, is going to be able to be sustained by the person buying the business because we still have to take into account that owner financing payment. Because even though it's not technically, you know, with a bank, it's still a debt that has to be repaid.

SPEAKER_00 11:46

You know, and and it's it's you you mentioned this, but I think it's worth noting aside from the the banking details on this, if I'm a buyer wanting to buy a business as much as possible, I want to make sure that there's business continuity when it's handed over to me from the current seller. So um, if I'm buying a restaurant, is the cook or the chef staying? What about the the head person that's that's handling the service on the front end of the business? Um, how clean are the books? Am I gonna be able to understand how much I'm paying my vendors? Are the vendors gonna stay with me? Is the lease gonna be able to be transferred? I need as much consistency going forward to know that I'm gonna be successful. It's the same thing that the bank looks at.

SPEAKER_01 12:28

Yes, 100%. Yeah. I can't tell you how many times, you know, one business owner is leaving or selling their business because ultimately they're gonna go start another one. And a lot of times they take those key players with them. Yeah. And if they're taking those key players with them, how are you as the buyer going to step in and ensure that operations still flow without those key people that are operating the business currently?

SPEAKER_00 12:50

Yeah. We we like to as much as possible get all of that in writing as part of the asset purchase agreement. Um now, some of it you can't predict. You you don't know if somebody's really gonna stay or not. But what you can do is uh talk to the seller and say, hey, listen, you're agreeing that you're not going to take these people when you go. If they leave on their own accord, that's fine, but you're not gonna poach the folks to go because I'll be counting on them.

SPEAKER_01 13:13

Yes, 100%. And that's why um, you know, a good non-compete can really help a deal.

SPEAKER_00 13:19

It it can. And that's really, I mean, there's so many things to look at um when you structure the deal. A non-compete is super important. Yes.

SPEAKER_01 13:28

Yeah, yes.

SPEAKER_00 13:29

So what are the most common issues that make an acquisition harder to finance?

SPEAKER_01 13:33

Well, the number one thing is financials. I'll tell you right now. Um, I see too often messy or incomplete tax returns or financials from the business being sold. That is the number one headache that we usually in hurdle, we have to jump through uh hoops to try to piece together the puzzle, missing tax returns, inconsistent financials. A lot of times we see company prepared financial statements versus ones prepared by a certified CPA or an accountant. Um, you know, company prepared are fine for, you know, maybe quarterly reporting or even mid-year. But when you really come down to brass taxes with your year-end numbers, you want those looked at by a certified professional. Um, so those can all be red flags from the start with your lender, with your bank. If we analyze financials and business is below a 1.15 debt coverage ratio, DCR, like we were talking earlier, you know, that can signify that the business is in a fragile state because most banks, they have a policy-conforming debt coverage ratio. And that can be anywhere I've seen from 1.2 all the way up to a 1.3 coverage ratio. Right. The closer you get to that 1.1, that means the business is breaking even. So why would you want to buy a business that's not making any money? That's right. Um, a thin cash flow is like thin ice. You might make it across, but nobody feels good about it. So the lower those margins, you know, it's it's a red flag for us for sure.

SPEAKER_00 14:57

Yeah, you know, and the other thing that maybe we should talk about at this point are uh are addbacks. So uh when when we as business brokers look to do a business valuation, typically we do a business valuation specifically so that we know how much the business is worth when we go to sell it. Right. There are other uh people who are certified in doing business valuations that will do them if you need it to be certified in court. You know, if you know you're going through a breakup and you're having to break up the business or whatever, that's an even more involved one. But one of the typical things you do when you do a valuation is you do uh this process of looking at what can be added back to the value of the business that the owner through their own discretion has taken out.

SPEAKER_01 15:41

Yes.

SPEAKER_00 15:42

Um I always err on the side of conservative. If I don't think the bank will include it, I don't include it either.

SPEAKER_01 15:48

Right. Yes. Yeah. The tune that banks more than not will add back is always going to be your depreciation and your interest. Yep. Um there are, like you said, other factors at play where there could be some add back features, one-time expenses, things like that. But no, we we try to be very conservative as well at the bank level. All banks I've worked at have have had that mentality. And so um typically you will add back depreciation and interest, but past that, we want to see how it looks without having to get fancy in the cash flow.

SPEAKER_00 16:16

Yeah, the the one other one that we always go back and forth with uh sellers on when we're valuing their business is well, what about my owner's compensation? The first question I ask them is is okay, do you work in the business in any capacity? And then usually the second question, because the answer to that one is usually yes, is okay, would the new owner have to hire somebody to go do that? If so, we'll take your owner's compensation and we'll discount it by that amount. Right. But I'll we'll also tell them keep in mind the bank wants to know that you're getting something out of this business. So the bank may not agree with us that if we take the rest of it as owner's compensation, that it's a valid ad back. And we'll have that conversation with them up front to make sure that they're not unreasonably thinking that there's a bunch of adbacks that that will help them.

SPEAKER_01 17:06

Yes, no, for sure. And you made that point very crystal clear because why, as the new owner, would I not want to take, you know, an owner compensation of a business that I'm running, um, if I'm especially if I'm in it day to day, that's the whole point. Most people want to go out and start a business or buy a business is because they want to work for themselves. They want to be, you know, unreliant on another person for their income, but ultimately they want to get paid.

SPEAKER_00 17:31

That's right.

SPEAKER_01 17:32

People want that cheddar.

SPEAKER_00 17:33

That's right. They do. They do. They want that money and they want to come. That's why they did it. You know, it's it's fine. Most most buyers, and we tell sellers this all the time. Is this why would somebody want to buy your business? One is most buyers think they're already smarter than you, that they can run the business better than you. And it's interesting. Most sellers go, yeah, I I know somebody could run this business better than I could. Um, but it is one of those things that, you know, that's part of the ambition of being a buyer, is I can do this and I can do it better. Um, that's great ambition to have, but just keep in mind, you know, the the bank is is is not funding your ambition. The bank is funding math.

SPEAKER_01 18:07

Yes, math and risk.

SPEAKER_00 18:08

And risk, yes. So this is probably a good place for us to break. Um we have a lot more to talk about, but we'll handle that in our next episode. Um, for now, though, it's been a great conversation about how bank financing works from the buyer side, when to involve a banker, how lenders evaluate the buyer and the business, and what makes a deal bankable and what can make financing harder. Um, but before we wrap, uh, we always have this segment at the end where we talk a little bit about uh local business news. So I'm gonna give a couple of business updates on what's happening in northwest Arkansas. Feel free to chime in with any comments you have.

SPEAKER_01 18:42

Yeah, let's hear them. I love hearing what's going on here.

SPEAKER_00 18:44

Yeah, there's there and there's some cool, cool business uh news that's come up. So um we just wrapped up uh National Small Business Week, which I should have known. I didn't know.

SPEAKER_01 18:55

I did not know that either. So you're not alone there.

SPEAKER_00 18:58

But you know, for National Small Business Week, it's interesting. There were actually two businesses in the local area that were recognized natur uh nationally. Uh the first one um is uh a Fayetteville restaurant called the Farmers Cafe.

SPEAKER_01 19:10

Okay.

SPEAKER_00 19:11

And the other one is a um a uh a uh Bentonville uh based um uh therapy business called Gateway Family Therapy and Wellness Services. And both of them were honored for their achievements, which I think is a huge feather in the cap of um Northwest Arkansas in general, but those businesses. So congratulations to both of those businesses. Um we love Farmers Guy. Yeah, isn't it great? Yes. Yeah, I love going there. Yep. It's one of my daughter lives in Fayetteville and we we we tend to go down there and eat there with with uh her and my son-in-law. And it's a great reminder that local grit and community focus still win big in this fast-growing region.

SPEAKER_01 19:48

Yes.

SPEAKER_00 19:49

Um, next bit of news is that there's a new multi-use development in Rogers that's creating a dedicated space for smaller community-oriented businesses right in the middle of the major business hub. The collection at Uptown, which is we're sitting in the Uptown area right now here in Pinnacle Heights, um, shows how mixed-use projects can help independent operators thrive alongside the big players in Northwest Arkansas. You know, I think one of the things that um we often talk to small business owners about is how do you leverage the local ecosystem? We're so blessed in Northwest Arkansas to have Tyson, Walmart, JB Hunt kind of creating this foundation for the community. Um, it helps with the nonprofits, it helps for with for-profit businesses, but the more that you can find your niche to fit into this ecosystem, the more successful you're gonna be.

SPEAKER_01 20:37

No, I completely agree. We are very blessed to live in our NWA bubble and very blessed to have, you know, those big players you just named that contribute to our economy here and our community here.

SPEAKER_00 20:48

So Yeah, yeah, it is, it is pretty remarkable. Um, the last one I'll mention is that the first quarter 2026 numbers were in. Northwest Arkansas's commercial real estate market remains strong, according to Sage Partners. With continued growth in real retail, office, and mixed use, it's a solid time for small business owners thinking about expansion, relocation, or new leases in Bentonville, Rogers, or Fayetteville. You know, it's it is a really good indicator that um I think I heard there's like 35 or 36 net new people uh coming to Northwest Arkansas.

SPEAKER_01 21:22

Yes.

SPEAKER_00 21:23

And and we also have this natural entrepreneurial spirit um in Northwest Arkansas. So there's no better time to start a small business.

SPEAKER_01 21:31

No, definitely not. And, you know, go see your good local banker for help with that. That's right. That's right.

SPEAKER_00 21:38

Um, and I I can't stress enough how um how much it has helped to be able to talk to a bank and just run things by them and say, well, how would you look at this? And how would you like us to present this when it's ready? And and, you know, what I've found is uh the success rate for our deals goes up the more I talk about the deals with the banker even in advance.

SPEAKER_01 22:00

Yes, yes, for sure. You're able to vet the process, vet the business, um potentially open up to some questions that maybe you didn't think of that the banker may have seen before.

SPEAKER_00 22:11

So yeah, yeah. So those stories that we just covered, um, they all point to the same thing. Northwest Arkansas continues to be a strong environment for local business owners, whether they're growing, relocating, expanding, or just trying to understand where opportunity is moving. And that obviously connected directly to our conversations today, which uh, you know, is super exciting. Thank you again for joining us. Yes, thank you, Ken. Hopefully, everybody in the audience will join us for the next episode because we still have tons to talk about. Um, but for now, thanks for listening to the Owner to Owner podcast. If you're thinking about what's next for your business, remember the best outcomes are built well before a deal ever happens. And that's a wrap for this episode. Thanks for listening to Owner to Owner. If you're thinking about what's next for your business, remember the best outcomes are built well before a deal ever happens.