Most business acquisition loan providers require that buyers of a business provide a down payment, often referred to as an equity injection, in order to get a loan. The equity injection can range from 5% to 30% of the transaction value. In this article, we discuss why lenders require a down payment and describe four sources of down payment funds.
Why do you need a down payment?
Lenders require an equity injection because they want to work only with borrowers who are committed to the business that they are acquiring. The down payment ties the buyer to the business since they could lose that money (and more) if things go wrong.
Perhaps this requirement is best understood by looking at the opposite side of the situation. What would happen if lenders had no down payment requirement for a loan? Individuals could acquire a company by using little (if any) out-of-pocket funds. And, if things go badly, the most likely scenario is that borrowers would walk away from the business. This outcome would leave the lender with a failing business. Obviously, lenders want to avoid this result at all costs.
Equity injection sources
In this section, we discuss three sources that can be used to raise funds to cover the down payment for an acquisition loan.
1. Personal savings
Your first source of funding is to use your (and your business partner’s) personal savings. This strategy works well in cases where individuals having been saving money for a while, preparing for the time when they would purchase the business. This strategy requires patience, dedication, and the foresight to know that you eventually want to buy a business.
3. Stock accounts
The second tier of funding is to liquidate your existing stock accounts and convert them into cash. This strategy can have some tax implications, or even losses, if done incorrectly. You should not use this source of funds lightly. If you choose this option, we suggest that you also work with a competent financial planner.
3. Your existing business (if you have one)
If you already own a business, a third tier of funding can be your existing business. If your business has assets that can be leveraged, you can get loans against them and use those funds to acquire the new business. This method is more common in scenarios where one company is merging/acquiring another one in the same industry. These transactions often occur as a leveraged buyout.
Note that leveraging your existing business also has risks. You are tying your existing business to the fortunes of your newly acquired business. If things go wrong, you could lose both companies.
Your home equity and retirement funds
If you own a home, you could get a home equity line of credit and use those funds as part of the loan down payment. Likewise, if you have a substantial retirement account, you could do the same. Or, you could even use both sources of funding.
While some individuals have used these two sources and done well, there are many who have not. This strategy is extremely risky since individuals are putting their family home and retirement at risk. It’s best to consider less risky sources to raise the funds for your acquisition down payment.
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Note: This article is provided for information purposes only and is not intended as financial advice. If you need advice, seek a competent financial adviser.