How to finance a business acquisition
Options for buying a business
- A combination of financing mechanisms can help you purchase a business.
- Term loans and SBA loans are the most cost-effective but carry strict eligibility requirements.
- Seller financing is a common way to help meet lender equity requirements.
- Employee stock ownership plans
Not every entrepreneur has a headful of start-up ideas. Buying an existing business can be less risky than building a company from scratch. The up-front cost to purchase certainly is more expensive, however. Once you’ve thought about how to buy a business and identified a great company at a fair market value, you’ll be in the market for financing to help close the acquisition.
Conventional term loan
Conventional business term loans are repaid at a fixed amount and period. Loans typically are secured against the existing business’ collateral — known as asset-based financing — making interest rates some of the lowest among business financing options.
While lenders prefer the lower risk profile of purchasing an existing business over funding a start-up, business term loans are still difficult to qualify for, and carry extensive documentation and eligibility requirements. In addition to a credit score of at least 680, lenders generally require a down payment of at least 20 percent of the value of the business to be purchased.
It is not uncommon to apply multiple times before being approved for a business term loan, and they can take up to several months to fund.
SBA 7(a) Loan
The U.S. Small Business Administration’s 7(a) program guarantees loans of up to $5 million for a business start-up or acquisition. A down payment of 10 to 30 percent is required but does not necessarily need to be cash from the borrower. For example, the seller can provide the equity to help move the loan forward, discussed further below.
SBA loan applications are as complex as conventional term loans. Typically, they require a personal credit score of at least 680 as well as personal financial statements, three years of personal tax returns and loan application history. The SBA also wants three to five years of management experience — particularly in the industry you are entering with the business acquisition. You must provide the balance sheet of the business to be purchased; two years of business tax returns; the bill of sale and terms of sale; company valuation and asking price; and an inventory list. Lenders may require additional information. SBA 7(a) loans are typically secured by the assets of the business to be purchased, and also carry a guarantee fee of up to 3.75 percent.
SBA 7(a) loans can take as long or longer than a conventional business loan to fund. There is an alternative SBA 7(a) Express program for loans of up to $350,000, where applications are processed within 36 hours.
With seller financing, the seller effectively acts as a lender, receiving payments and interest from the buyer on the sale price of the business. As with lenders, the seller runs a credit check on the buyer and assesses finances and industry management experience. Seller financing often is more flexible than conventional financing, as there are key benefits gained by both parties with this option.
Sellers potentially receive a higher asking price if they are willing to receive monthly payments rather than a lump sum. They can also reduce their capital gains tax burden when using seller financing, which is taxed as an installment sale rather than a lump sum real estate sale.
While seller financing can comprise an entire business purchase, it is typically one component — usually 30 to 60 percent — of a financing mix with an SBA loan or conventional term loan. This is an attractive arrangement for the buyer because the seller’s financing helps meet the lender’s equity requirement.
This arrangement also gives the lender increased confidence in the sale, as the seller remains invested in the continued success of the business. The primary risk for sellers is that they assume second lien positions, behind the lender, on the buyer’s assets should the buyer default on the loan.
As the seller has a vested interest in the buyer being able to make monthly payments, interest rates are usually low and on par with conventional bank financing. When purchasing a business with little money down or limited collateral, seller financing is a useful option, either as a stand-alone or as part of a financing mix.
Rollovers for business startups
Rollovers for business startups (ROBS) are an option to finance a purchase or fund enough equity for a conventional or SBA loan. With ROBS, borrowers tap into a retirement account by rolling over funds to purchase a business. Since you are accessing your own savings, ROBS is neither debt nor subject to taxes and can be arranged more quickly than a loan.
There are several drawbacks to ROBS, however, primarily that you are risking retirement money that would otherwise be appreciating. Moreover, most ROBS providers or lawyers required to execute the transaction charge hefty up-front and monthly fees.
Employee stock ownership plan
With an employee stock ownership plan, non-voting shares in the company are sold to employees, generating the necessary funds for the sale of the business. The buyer retains the voting shares and control of the company. While this is a more common arrangement for a business owner who wants to transfer ownership to employees, an outside buyer can also use it to generate cash for an acquisition.
Negotiate, review and compare
Once you have negotiated a financing arrangement with the seller, have your lawyer review it. Then, compare lenders for the best loan. Depending on your down payment and collateral, a combination of financing types may be the most cost-effective for all involved.