In this article, we discuss six ways that you can finance the purchase of a business. We also examine three ways to cover the operational costs of your business. Many buyers forget to take into account this important point when making their initial plans. Financing the business acquisition is only part of the game. You still need funds to operate the business after the purchase.
This article will help you if:
- You have already selected your business acquisition target
- The business you want to buy is in operation
- The business you are planning to buy costs between $1M and $10M
- You have funds to contribute to the transaction (see the next section)
Finance the Purchase
In this section, we discuss the six most common ways to finance small business purchases. Most purchase transactions are structured using one, some, or all of these methods.
1. Your Own Funds
The simplest way to finance a business acquisition is to use your own funds. These funds include your savings, retirement accounts, and home equity. Although you will need to use some of your funds for the purchase, it’s uncommon for someone to acquire a business by using only their funds for the purchase. Otherwise, few people would be able to acquire larger businesses. Instead, most buyers use their funds in combination with seller financing and/or a business loan. This leverage allows them to purchase larger companies.
2. Seller Financing
Another common way to finance an acquisition is to ask the seller to provide financing. In this case, the seller provides you with a loan that is amortized over a period of time. You pay the loan back, usually from the proceeds of the business. Business buyers like seller financing because it is easier to get than conventional financing, it’s more flexible, it gives the seller a vested interest in disclosing accurate performance information, and it can be cheaper.
On average, sellers are usually willing to finance 30% to 60% of the agreed-upon sale price. Few (if any) sellers will finance more than that, unless you are a strong buyer with substantial assets and a large down-payment.
Also, expect that seller financing will be provided only after the seller has done their due diligence on you. Therefore, the seller will want to see your credit, assets, experience, and business plan.
3. Bank Loan
Getting a conventional loan (e.g., a term loan) from a commercial bank to finance the acquisition of a company can be very difficult. As a rule, banks lend funds against existing assets and not against business plans. Thus, to get a loan, you must have substantial assets, good personal credit, and a solid track record in the industry. For most conventional borrowers, their best bet is to get a bank loan guaranteed by the Small Business Administration (SBA), as covered in the next point.
4. SBA Loan
One of the best options to finance a business purchase is to use an SBA Loan. Actually, the SBA itself does not lend money. Rather, it provides guarantees and safety measures for banks who, in turn, can lend money to fund acquisitions. While the SBA sets some minimum qualification guidelines, banks have the freedom to add to those guidelines as they see fit.
Generally, borrowers using a 7A loan can get up to $5M to cover most (or part) of the purchase of the business. To qualify, potential borrowers must:
- Have decent credit
- Be able to put 10% down (part of this can be paid through seller financing, see #2)
- Provide personal financial information
- Provide three years of tax information
- Show they have ample experience in the industry that the purchase target is in
5. Leveraged Buyout
One common financing structure to buy a small business is a leveraged buyout. Leveraged buyouts allow buyers to maximize their returns by minimizing the cash they invest. While leveraging assets can increase returns, it does have a major disadvantage. If things don’t go well, leverage can also maximize your losses and have a large negative impact on your rate of return.
In principle, the transaction structure can be relatively simple. You leverage some of the assets of the business, such as equipment, real estate, or inventory, to help finance the acquisition. In small companies, leveraged buyouts usually involve the combination of seller financing and a bank or SBA loan.
6. Assumption of Debt
There are two common ways to acquire a business. You can purchase either the assets or the stock. If you buy the assets, that is exactly what you get – without any of the “bad liabilities” (think “future lawsuits”). On the other hand, if you buy the stock, you get all assets, liabilities, and risks.
Most business “asset-purchase” acquisitions involve the transfer of some assets and liabilities. This point is important because part of your payment to the seller may be the assumption of existing business debt. This process can get complicated, as you often need the approval of the debtors before assuming the debt.
Entrepreneurs commonly look to acquire businesses for “no money down.” Basically, these entrepreneurs are hoping to get 100% external or seller financing. For all intents and purposes, these transactions do not exist.
Think about this point from the seller’s (or lender’s) perspective. What is their incentive to give someone 100% financing? If they are a seller, they would have to be desperate. And lenders usually want to see new owners who have some “skin in the game.”
While some transactions could meet this criteria – they are like winning the lottery. In other words, “possible, but not probable.” It’s best to prepare to put some money down.
Keep Closing Costs in Mind
Remember that getting financing usually increases your closing costs. These closing costs, which include your contribution to the purchase of the business, come from you – the buyer. The amount you need to budget for closing costs varies based on the size and type of business you are looking to acquire. Budgeting at least 10% of the purchase price for closing costs is a good idea – and more (20%) is usually better.
Buying the business is only half the battle. You still need to ensure you have enough funds to operate the business successfully once you acquire it. If you will need additional operational funding, it’s best to negotiate it when you are negotiating the purchase. Trying to get funding immediately after purchasing the business can be difficult.
This section discusses common ways to finance operations.
1. Cash Reserve/Self-Funding
The easiest way to finance operations is to use a cash reserve. This reserve can be initially funded by your own funds. However, it should eventually be financed by the cash flow of the business. You can also improve your cash reserve by paying your suppliers on net-30 or net-60 day terms, rather than paying immediately.
2. Line of Credit
Another effective way to finance operations is using a business line of credit. This revolving facility allows you to borrow as needed and can be paid down as your cash flow improves. It is one of the most flexible ways to finance the operations of a business. However, qualifying for a line of credit can be challenging. Learn more about line of credit qualification requirements.
3. Invoice Factoring
Lastly, one of the more common reasons businesses experience cash flow problems is that their cash reserves run low and they cannot afford to wait 30 to 60 days to get paid by their customers. This problem is common for companies that sell to commercial clients and it can seriously impact operations.
You can improve cash flow by using invoice factoring. This solution finances your slow-paying invoices and improves the cash flow of your business. It is easier to get than other types of funding and can work well with corporate acquisitions. For more information, go here.
Business Acquisitions Often Use Multiple Sources of Funding
In closing, keep in mind that it is common to use more than one source of funding to acquire a business. For example, assume that a partnership of individuals wants to purchase a $7M company. One way to structure this transaction would be to use:
- $4,000,000 from an SBA Loan
- $2,000,000 through seller financing (perhaps with some standstill provisions)
- $1,000,000 in purchaser funds from partners
Additionally, the partners may want to include a line of credit or a factoring line to handle cash flow after the sale closes. Obviously, this scenario is just one example. There are other ways to structure this transaction depending on the nature of the business, it’s assets, and the background of the purchasers.
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.