Summary: Many new business buyers request a prequalification letter from a lender before looking for opportunities. They hope this letter shows sellers they are "prequalified" to buy their company. Unfortunately, business acquisitions don't work that way. Lenders can provide a prequalification letter only after their initial due diligence of the business you want to buy. This article explains how the process works and what to expect. We cover the following:

1. How it doesn't work (read first)
2. What does a lender prequalify?
3. What do you need to get prequalified?
4. What does a lender prequalification get you?

1. How it doesn't work

We typically get a few clients requesting to be prequalified for a business acquisition loan every week. Usually, these clients are beginning the process and are about to start looking for a business to buy.

From a buyer's perspective, this approach seems reasonable. Early prequalification could help them start the search process and show sellers or business brokers they have some financial backing. Unfortunately, things don't work like this in business acquisition financing.

a) The lender's perspective

Consider this situation from the lender's perspective. What exactly would the lender prequalify without any details about the transaction? Not much. Let's take that a step further. Even if you could get such a prequalification (you can't), what would it get you? Realistically, it would be of little or no value.

Business acquisition lenders don't provide prequalification letters until they have finished their initial due diligence of the transaction. Furthermore, we are not familiar with any lender that can offer a useful prequalification letter without reviewing the transaction first.

The following section explains why due diligence is essential before providing a prequalification.

2. What does a lender "prequalify"?

The prequalification process is more comprehensive than most new business buyers expect. This process applies to Small Business Administration (SBA)-backed loans and most conventional loans.

A lender can make an objective qualification decision only after examining the following:

• Buyer
• Business
• Collateral
• Proposed transaction structure

The lender performs a high-level transaction review to determine if the transaction qualifies for an acquisition loan. They need to determine the following five things.

a) Can the buyer manage the business?

Each lender has its own criteria based on its risk tolerance. The lender must determine the borrower's ability to manage the business they are buying. After all, only a capable buyer will be able to operate the business profitably and repay the loan.

Lenders examine the buyer's work and business experience and compare it against what the business requires. Generally, a buyer with experience working in the type of business they want to acquire has a higher chance of success. Conversely, a buyer with limited work or business experience is less likely to succeed.

b) Can the buyer manage the equity injection?

Buyers usually have to contribute around 10% of the project cost as an equity injection. This requirement can sometimes be lowered to 5%, provided the seller is willing to provide financing and have a "standstill."

We are not familiar with any lenders that will finance an acquisition without an equity injection from the buyer. The equity injection is an important feature that protects lenders.

The equity injection must come from certain sources. Usually, the equity injection comes from the buyer's savings and investments. Equity injections cannot be financed or provided by the seller.

c) Can the business afford the loan?

Lenders finance transactions only if the business can pay for the cost of financing out of proceeds. The business must also be able to pay its regular business expenses, including owner's compensation. Transactions with a company that can't afford to pay financing out of proceeds will likely be declined.

d) Does the transaction structure work?

Lenders need to examine the details of your proposed transaction structure and determine if they can finance it. The first step is to determine if the offered amount is in line with a reasonable valuation of the target company. Additionally, lenders review other details, including the financials, Seller's Discretionary Earnings (SDE), working capital requirements, seller financing (if offered), etc.

e) Does the transaction make sense?

The lender reviews all its information about the buyer, target business, equity injection, and transaction details to determine if they meet its requirements. A lender issues a prequalification letter only if the transaction as a whole makes financial sense. This explains why lenders may decline seemingly strong transactions simply because of one limitation. Examples include transactions with strong buyers but weak businesses, inexperienced managers acquiring a strong company, etc. All the transaction components must be strong.

3. What do you need for a prequalification letter?

The requirements vary by lender. In general, you must provide the following:

• Signed Letter of Intent
• Borrower information form (form 1919)
• Personal financial statement (form 413)
• Three years of personal tax returns
• Three years of business financial statements
• Debt schedule
• Resume (showing management experience)

Most lenders are able to provide a prequalification letter after reviewing this information. The initial underwriting can take a week or longer. This timing depends on the details of the transaction and the lender.

4. What does a prequalification get you?

You have gone through the effort of structuring and submitting a transaction to the lender, hoping the transaction qualifies. The lender reviews the transaction and issues a prequalification letter. What does the letter actually get you?

A prequalification letter does not necessarily guarantee that the lender will finance your acquisition. Furthermore, there are no standard prequalification letters. Each lender uses its own version.

Some letters just list the terms you will get along with a time frame but don't provide assurances. Other prequalification letters are stronger and almost resemble commitment letters.

a) The reality

In our experience, a transaction is not guaranteed until it's funded. We have seen transactions fall through at the last minute due to unexpected complications. It's the nature of business acquisitions.

We prefer to view prequalification letters as merely a step toward getting a business acquisition loan. If you get the letter, it means your transaction moves to the next step. This step involves the final due diligence and getting a formal commitment letter.

Want to finance a business acquisition?

The first step to work with us is to submit this form. Once we review it, one of our associates will contact you to discuss the specific details of your acquisition.

Editor's note:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.