Buying an established business is often seen as a lower-risk strategy to get into business ownership. Few entrepreneurs can buy a business outright, and most use a loan to finance the acquisition. In this article, we discuss:
- Are acquisitions a good strategy?
- How much does it cost to buy a business?
- Who provides acquisition loans?
- What are the loan qualification requirements?
- Getting prepared for the loan
- How to get an SBA acquisition loan
- Common underwriting problems
1. Is buying an existing business a good idea?
Many entrepreneurs wrestle with the question of launching a new business vs. buying an established company. I have been through this challenge myself. Frankly, if I had to do it all over again, I would have done things differently. Instead of launching a new business, I would have acquired many small companies that were simple to manage.
In my opinion, buying an established business is better than launching one from scratch. Here are some advantages of acquiring the right company:
- The business has a value
- The initial investment is lower (if you use a loan)
- You can take a salary
- The company has a track record
- The infrastructure is in place
There are many other advantages, but you get the idea. Keep in mind that this strategy is not perfect. Buying a business has risks, and you could get stuck with a lousy business. In most cases, however, the risk is lower than it is with launching a new company.
2. How much does it cost to buy a business?
One significant advantage of buying an established business is that you can use a loan to acquire it. Consequently, you only have to invest a small percentage of actual equity to own the company. Launching a brand new company is different. The founders need to pay for everything outright. Getting a loan from a lender to launch a business is very difficult. This often leaves founders asking friends and family for money.
Let me give you an example. Let’s assume the all-in cost of acquiring a business is $1,000,000. If the business acquisition can be financed, you need to invest only 10% to 20% of the total amount. So, the amount of upfront money needed to buy the business in this example is $100,000 to $200,000. The remaining $800,000 to $900,000 is financed through a loan and paid back through monthly installments out of the target company’s cash flow. Using this model can be a huge advantage.
Keep in mind that using financing – or “leveraging,” as it is called – is a double-edged sword. It can maximize your gains if things go well. However, it can also eliminate your equity if things don’t go as planned.
3. Acquisition financing providers
In general, you can get a loan to buy a business from the following sources:
- Banks
- Private lenders
- Small Business Administration (SBA) providers
- Private equity companies
- Private investors
Most small business acquisitions under $5,000,000 are financed using an SBA 7(a) loan. I think SBA-backed loans are one of the best options for small business owners. They are cheaper than conventional bank loans. They also have easier qualification requirements. However, there are some transactions that can’t be financed with an SBA-backed loan. In those cases, your only options are to work with banks, investors, or Private Equity (PE) firms.
Private investors and lenders are more expensive than SBA-backed loans. They each have specific qualification requirements, with banks having stricter requirements. Lastly, larger transactions are best financed through a PE firm. Remember that the PE firm’s objective is to exit the transaction profitably. They are not long-term investors. Consequently, having an exit strategy that allows them to cash out eventually is vital.
4. Loan qualification requirements
Qualifying for an acquisition loan is never easy. Buying a business takes a lot of work. The qualification requirements of lenders vary significantly. Since most small business acquisitions are finances using SBA-backed loans, we will focus on those. The qualification requirements to use an SBA 7(a) loan to finance an acquisition are:
- Reasonable personal credit score (>650 or so)
- Funds to cover a 10% to 20% equity injection
- A signed letter of intent (LOI)
- Borrower information form (form 1919)
- Personal information form (form 413)
- Three years of personal/corporate reports
- Three years of financial statements
- Reasonable debt schedule
- Management experience
- DSCR of 1.15 or better
Every lender that provides acquisition financing requires an equity injection (i.e., down payment) of 10% to 20%. As far as I know, no lender offers 100% financing for small opportunities.
A lender or the seller cannot finance the equity injection. It must come from the buyers and their partners. Getting the funds to cover the equity injection is one of the hardest parts of buying a business. However, the equity injection is still less than the total cost of launching a comparable business.
5. Getting prepared for the loan
There are a few things you should do before you consider evaluating lenders. Preparing these items ahead of time will streamline the lender discussions and help the transaction move along.
a) Determine your net worth
An entrepreneur can get an SBA-backed acquisition loan even if his net worth is minimal. However, even if your assets are minimal, you need to disclose everything you own to the lender. Review your financial records and add up the numbers. Include everything your partners and you own, such as bank accounts, stock accounts, business equity, real estate, and so on.
b) Check your credit
SBA-backed lenders require a minimum credit score of 650 to 680. If you don’t meet this criterion, consider working with a CPA or similar professional to help you clean up your finances.
c) Gather the funds for the equity injection
You should have the funds for the equity injection by the time you call the lender. It’s the first thing that lenders check. Common sources include:
- Personal savings
- Stocks
- Mutual funds
- Funds from other businesses
d) Gather three years of tax records
Lenders review your tax records as part of their due diligence process. Have those records ready by the time you start contacting lenders. Tax problems can derail your chances of getting an acquisition loan. Consider working with a CPA if you have tax problems.
6. How to get the acquisition loan
Getting an acquisition loan can take a couple of months and involves a lot of back and forth between the buyer, lender, and seller. The process takes a few months, from beginning to end.
a) Find a lender
Entrepreneurs can get an SBA-backed loan from participating banks and lenders. There is one important caveat to keep in mind. Not all SBA backed lenders – or loans – are the same. Each lender has its risk preferences and areas of expertise. Some lenders are more flexible than others. Consequently, you need to do some research. Consider doing your research once you are close to finalizing an offer letter and know the terms of the deal. Otherwise, there will be little to discuss with a lender.
b) Provide a complete application
Once you find a lender you are comfortable with, submit a complete application. The process should be straightforward if you followed the suggestions outlined in step #5 and if the transaction meets the qualification requirements outlined in step #4.
c) Go through the underwriting process
The underwriting process starts once the lender receives the application. They review the buyer and the target business and ensure that the transaction makes financial sense.
The lender examines the buyer’s assets, liabilities, and work experience. Lenders also look at the acquisition target’s financial track records, assets, liabilities, and valuation. If all goes well, the loan is approved for funding, and the transaction moves to the next stage.
d) Fund the transaction
With the underwriting part complete, the transaction moves to the closing stage. Usually, an escrow agent distributes funds, assets, and stock certificates as needed. The business is now yours. If you want to see an example of an acquisition, read this case study that details a transaction we funded.
6. Common problems that derail acquisitions
Every acquisition has challenges that the buyer and seller have to work through. Here are four of the most common issues we see when funding these transactions:
a) Buyers can’t get the 10% to 20% equity injection
Every so often, we see transactions in which the buyer cannot get the equity injection. This can happen for various reasons, such as the inability to liquidate assets, partners backing out, and so on. We recommend that buyers have the funds in place before looking for financing.
b) Target company is overpriced
An acquisition is inherently adversarial. Sellers want to get the highest possible price for their company. On the other hand, buyers want to acquire the company at the lowest possible price. This conflict can lead to pricing discrepancies during the underwriting process.
Lenders work hard to ensure that they don’t finance an overvalued transaction. Any uncovered issues during the transaction’s evaluation or appraisal can affect the size of the loan they are willing to offer. This situation leaves the buyer with two options. They can make up the difference by adding equity, or they can renegotiate the price. If the negotiations fail, the transaction falls through.
c) Buyer has no experience in the industry
In some transactions, the buyer has minimal (or no) relevant experience in the target company’s industry. They look at the transaction as a way to get into the industry. On the other hand, lenders finance only transactions in which the buyer has work experience managing a company in the target company’s industry. You can see the problem here.
In these cases, the buyer can fulfill the lender’s requirement by hiring one of the target company’s managers for a contractual period of time. This step assures the lender that the company will be well managed during the transition and new ownership.
d) Seller cannot provide accurate financial information
Small businesses are notoriously bad at keeping accurate financial records. A lender will not move forward with the transaction if they cannot get reliable financial statements. In my opinion, it’s best to walk away from those transactions. The last thing you want to risk is overpaying for a bad business.
Note: This article is for information purposes only and does not intend to provide financial advice. If you need financial advice, please consult a specialist.
