This question is common for entrepreneurs looking to buy their first business. The answer depends on how you plan to pay for the acquisition. In most cases, buyers use financing – since few people can afford to pay for a business in cash only.
We think that buyers actually have a different question in mind. What they are actually asking is: "If I can invest $X to buy a business, how much financing can I get?" This article explains how business acquisitions are financed and how to calculate the amount of financing you can obtain. It covers:
- The simple calculation
- How are acquisitions financed?
- How are acquisitions structured?
- How are working capital and capital expenditures financed?
- What are the due diligence and closing costs?
- How big of a business can I really buy?
The simple estimate
As we mentioned, most entrepreneurs purchase their companies using financing. The most popular financing option is Small Business Administration (SBA)-backed loans. Like all loans, SBA-backed loans require that buyers contribute a minimum of 10% of the project cost. This contribution is called an equity injection.
The dollar value of the 10% equity injection is important. It ultimately determines the approximate amount of financing you will be able to get. Consequently, your equity injection's dollar size also determines the size of the business you can buy.
We can calculate an approximate dollar value of the biggest business you can buy using a simple method. Divide the amount of money you have for the equity injection by 10% (or 0.10). This method provides the approximate highest dollar value project you can afford. Note that this method provides the total transaction value, not just the size of the financing component. Let's look at some examples to help you understand the details:
Example A: $50,000 equity injection
This equity injection allows you to acquire a $500,000 company. Divide $50,000 by 10% (0.10) to get $500,000. The $500,000 transaction is split as follows: $50,000 from the equity injection, and $450,000 from financing.
Example B: $100,000 equity injection
This equity injection allows you to acquire a $1,000,000 company. Divide $100,000 by 10% (0.10) to get $1,000,000. The $1,000,000 transaction is split as follows: $100,000 from the equity injection and $900,000 from financing.
This method has an important caveat
This method offers a reasonable estimate you can use if you are early in the acquisition search process. However, this calculation is not all inclusive. It does not consider other items that are part of an acquisition such as Working Capital or Capital Expenditures (CapEx) allocation. It also does not consider due diligence or closing costs.
Working capital and CapEx additions are important and affect the equity injection basis. Consequently, you need to take them into account. Keep in mind that both these costs vary substantially between transactions and cannot be estimated until you have a specific acquisition in mind.
How are small acquisitions financed?
To better estimate your acquisition buying power, you need to understand how transactions are financed and structured. Most small business acquisitions under $5,000,000 are financed using an SBA-backed loan and a combination of buyer's equity and seller financing.
a) Buyer's equity contribution / Equity injection
Finance companies require that buyers contribute 10% (with few exceptions) of the project cost. This contribution is referred to as the "equity injection" or "equity contribution."
The equity injection is a requirement to get financing. It cannot be financed or come from the seller. Funds for the equity injection usually come from personal sources such as savings or investments.
Note that the equity injection dollar value is based on the project cost rather than just the business's cost. The project cost includes the business's cost, working capital additions, CapEx allotments, and acquisition expenses. For more information, read "What is an equity injection?"
b) Seller financing
Sellers are a common source of acquisition financing. While sellers prefer to get paid immediately, they usually offer financing as an incentive to buyers. Buyers like seller financing because the terms tend to be flexible and the seller remains tied to the company until all payments are made. Sellers are less likely to over-sell their companies if they have to face the buyers for a few years after the sale.
On average, sellers finance up to 20% of the business purchase. They usually offer competitive terms. However, be careful of transactions in which a seller offers 100% financing. This scenario can indicate a troubled and hard-to-sell business.
Note that seller financing has no bearing on the size of the equity injection.
c) Small Business Administration
The SBA is one of the leading financing engines for small business acquisitions. They don't finance loans, as it is commonly believed. Instead, the SBA provides guarantees to specialized lenders on behalf of small business buyers. The SBA guarantees enable the lenders to offer financing at very competitive rates.
The qualification requirements for these loans are more attainable than those from conventional lenders. SBA-backed loans are capped at $5,000,000. For more information, read "How to get a loan to buy a business?"
How are small business acquisitions structured?
Most small business acquisitions are structured as leveraged buyouts. In these transactions, the buyer attempts to finance most of the purchase using a combination of SBA-backed financing and seller financing. Seller financing usually accounts for 5% to 20% of the acquisition. Lastly, the buyer must add a minimum equity injection of 10% of the project cost.
Few transactions are that simple, though. Most acquisitions involve loan additions for working capital and CapEx. Additionally, you have to take into account due diligence and closing costs.
a) Capital expenditures (CapEx)
CapEx are expenditures used to buy or improve physical assets. These include buildings, technology, equipment, and so on. This component can be significant since buyers often want to make improvements to their acquisitions.
The size of this allotment varies based on the specific requirements of the seller. CapEx allocations affect the basis of the 10% equity injection.
b) Working capital
Working capital refers to the funds that you can use to run your new business. Most lenders require that the acquisition target have a few months of working capital available. In most cases, buyers have these funds available personally. They usually ask lenders to add them to their loans. Working capital loan allocations affect the basis of the 10% equity injection.
c) Due diligence costs
Due diligence costs cover some of the lender's expenses to review the opportunity and determine if it can be financed. They vary based on the size, industry, and complexity of the transaction. These costs include:
- Business valuation
- Asset appraisals
- Financial review
- Legal costs
The borrower pays some of these costs upfront. Other costs can be bundled into the loan as part of the working capital component.
d) Closing costs
Closing costs are the expenses associated with getting the transaction funded. They include the following:
- Legal costs
- SBA guarantee fee (2% to 3.5% of the loan size)
- Titles and transfers
- Consultants, loan packaging, etc.
As with due diligence costs, the buyer can opt to bundle some of these costs into the loan. When this is done, the costs are added to the working capital component.
How big of a business can I buy?
As we said at the start of the article, the equity injection determines the size of the business you can buy. The injection is 10% of the total project cost. This leads to the next question. What is the “project cost”? The project cost is the cost of the business plus any allocations for working capital and CapEx. As a simple formula:
Project cost = Cost of Business + Working Capital + CapEx
Consequently, dividing your available funds for the equity injection by 10% (or 0.10) provides the largest approximate project cost you can afford. For example, a buyer with $100,000 available for an acquisition could finance a purchase whose largest project cost is $1,000,000 ($100,000 / 0.10). The $1,000,000 target is split as follows:
- Equity injection
- SBA-backed financing
- Seller financing
- CapEx allocations
- Working capital allocation
- Other expenses
Note that the amount of seller financing is not used to determine the size of your equity injection. Consequently, it has no significant bearing on the size of the business you can acquire. This is an important detail that many buyers overlook.
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.
Given the complexity of how businesses can be purchased and the products that are used, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.