Financing a Business Purchase

business acquisition financingWhen most folks think about becoming an entrepreneur, they often think about starting a company. That is certainly one way to become an entrepreneur.

However, another way to become an entrepreneur is to acquire an operating business. This method has some advantages over starting a business from scratch. If you perform your due diligence correctly, you can buy a business that:

  1. Fits your talents
  2. Has established customers
  3. Has revenues
  4. Has operating procedures in place

In this article, we discuss six ways to finance a business purchase. By the way, most of these tools are used in combination with others. I also cover this subject extensively here.

1. Your own funds

The easiest way to purchase a company is to use your own funds. As a matter of fact, this is how I started my company. You cash out your savings, stock accounts, options, home equity, and any asset that you have and use it to acquire the business. By the way, I am NOT an advocate of using home equity.

Now for a dose of reality. Most business acquisition transactions require the purchaser to invest some of their own funds. It does not have to be the whole purchase price, but it certainly has to be a meaningful percentage. Depending on how you structure the transaction, expect to contribute an average of 10% to 20% of the purchase price. However, your contribution may have to increase to 40% in some cases, and even to 100% if you cannot get any external financing.

2. Seller financing

Another way to finance the purchase of a business, or at least a part of it, is to use seller financing. Most sellers are willing to finance the purchase of their business by taking a note, amortized over a number of years. The percentage of the purchase price that the seller is willing to finance varies, but it ranges from 40% to 60%.

An advantage of seller financing is that it is easier to get than conventional financing, though you should expect the seller to perform their own due diligence. Also, getting seller financing gives you some comfort knowing that the seller stands behind their business.

3.  Friends and family

Another way to get funding is to ask friends and family for financing. While this can be easier to get than conventional financing, it can also create problems. In most cases, you are putting your relationship at stake. I do not recommend this type of financing, though there are some exceptions. You should consider this type of financing only if the friend or family member:

  1. Plans to be a partner
  2. Can contribute something more than just money (e.g., contacts, knowledge)
  3. Understands the risks

If they do not meet these three conditions, it’s best to look for financing elsewhere.

 4. Small Business Administration (SBA) Loan

The majority of business acquisition loans are made by banks that offer so-called SBA loans. Though the loans are made by banks, they have a guarantee from the SBA. This guarantee reduces the risk for the lender and serves as an enticement for them to underwrite “riskier” loans. However, the SBA guarantee is considered a last resort. Before using the SBA guarantee, banks will try to collect from the business and from the guarantors. This last point is very important. An SBA loan does not free you from your obligation to pay if things don’t go well.

Banks still go through their underwriting process and finance only businesses that have the cash flow and assets to pay back the loan. However, banks (and the SBA) understand that not every situation is perfect and, as a result, they can be flexible on certain parameters. That is the whole purpose of the SBA’s involvement.

Here are some detailed qualification requirements. In general, you must have:

  • A credit score of 650 or above
  • Experience in the industry the company operates in
  • The ability to pay a 20% down payment (10% in some cases)
  • Good tax records for the last three years
  • A need for up to 5 million dollars in financing

For more details on this subject, read “How to get a business acquisition loan.”

5. Leveraged buyouts

Most people associate using a leveraged buyout strategy with large companies. However, this funding strategy works for small businesses as well. For small businesses, the idea is to minimize your personal investment and maximize external financing through the use of loans, real estate financing, equipment financing, and inventory financing.

Entrepreneurs might use a leveraged buyout structure for two reasons. First, it can allow you to purchase a much larger business than you could afford with other financial structures. Second, the leverage can maximize your returns.

Leveraged buyouts have a catch though – and it’s an important one. They can easily eliminate any equity (and more) if things don’t go as planned. Because of this risk, it’s a strategy that should be used with caution.

6. Assuming debt

In some cases, you can pay part of the business acquisition cost by assuming some of the existing debts of the business. Debt assumption can be complex and can have a number of implications.

You will need some money down

Some entrepreneurs look for businesses that they can purchase with “no money down.” They hope they can qualify for 100% seller or bank financing. Now, think about it from the seller’s (or bank’s) perspective. Would you be willing to provide a buyer with 100% financing? Would you feel that your investment is safe? You would be funding an individual (or group of individuals) who have only invested time into the business – no real skin in the game. What is to prevent them from walking away if things don’t go well?

In reality, there are very few of these opportunities, and everyone is looking for them. It’s like winning the lottery. Yes, it’s possible – but it’s not probable. Expect to pay 10% to 20% as a down payment.

An acquisition example

Let’s assume that Fred and Sally are partners and want to buy Widgets Inc. for $7,000,000. After some negotiation, the seller agrees to finance $2,800,000 (40%). Fred, Sally, and the business meet the underwriting criteria of the lender and get a $2,800,000 (40%) loan. This means they can finance a total of $5,600,000, which is 80% of the purchase price of the business. To complete the purchase, they need $1,400,000 (20%) for the down payment.

Now, let’s assume that Fred and Sally can contribute only $700,000 (10%) to the transaction because they have no additional funds to spare.

Does this mean that the transaction is dead?

There is a way for this transaction to proceed. The SBA allows a 10% down payment if Fred and Sally get two things:

  1. Seller or bank financing for $3,500,000 (50%) and
  2. A standstill from the seller for two years

If they can get these two items (assuming an increase in seller financing), the transaction could proceed as follows:

  • $2,800,000 SBA Loan for 40%
  • $3,500,000 seller financing with 2-year standstill
  • $700,000 cash down payment from Fred and Sally