Summary: Most small business acquisitions are financed using a loan. While larger acquisitions have many financing options, smaller transactions typically rely on Small Business Administration (SBA)-backed financing.

This article discusses how to get an acquisition loan to buy a small business. We review what you must have in place before you apply, how to get the loan process started, and what to expect. The article covers:

1. How are business acquisitions financed?
2. Determine how much money you need
3. When should you start looking for financing?
4. What to do before you look for a loan
5. How to get a business acquisition loan
6. Conclusion

For more information about other methods of financing a business purchase, read our article about financing business acquisitions.

1. How are small business acquisitions financed?

Let's start by briefly discussing how most small business acquisitions are financed. This background information is important as it help you understand how transactions are structured. It also gives you an idea of what to expect when looking for an acquisition loan.

Entrepreneurs who buy an existing business typically finance part of the acquisition with a loan. The largest financing component comes from a business lender. They typically finance up to 90% of the transaction. However, the remaining 10% must come from the buyer and seller financing.

Most acquisition transactions are financed with a combination of lender financing, seller financing, and the buyer's contribution. Let's examine these three options in more detail.

a) Lender financing

Most business acquisitions under five million dollars use Small Business Administration-backed financing. The SBA plays an essential role in helping buyers acquire small businesses.

The SBA works with a network of lenders specializing in financing small businesses. This network program provides small business buyers with access to competitively priced financing.

It's important to note that the SBA does not provide loans directly. Instead, they provide guarantees to their network of lenders. These guarantees reduce the lender's risk, providing an incentive to make otherwise "risky" loans.

A lender never finances 100% of the acquisition cost. The risk of these transactions is too high. Depending on the transaction details, most lenders can finance up to 90% of the transaction value. The remaining 10% must be covered by the buyer's equity injection and seller financing.

Buyers are always required to contribute equity to an acquisition. The equity ensures the buyer has a financial participation in the transaction.

b) Buyer's equity injection

Lenders require that buyers contribute at least 10% of the transaction price as an equity injection. The equity injection must come directly from the buyers. This amount cannot be financed and cannot come from seller financing. As a reference, here is more information about equity injection sources.

Some lenders allow the equity injection to be as low as 5%, provided the remaining 5% comes from seller financing. In these cases, the lender also requires that the seller have a standstill on their note.

c) Seller financing

Seller financing is an important component of many small business acquisitions. Most buyers require that sellers finance a portion of the acquisition because it has some advantages. However, this aspect is negotiable.

The most important benefit is that seller financing provides buyers with some leverage over the seller. It can be used to enforce seller compliance with post-closing commitments, such as training.

The second benefit of seller financing is its flexibility. It typically has competitive terms and can be more flexible than SBA options in some cases.

Seller financing negotiations can be complex because the seller and buyer have opposing interests. Sellers prefer to get payment upfront rather than offer financing. Consequently, they negotiate to offer the least amount possible. Sometimes, they don't have much of a choice. The seller may have to offer financing simply because the lender requires it or as an incentive to sell the business.

In our experience, most sellers are willing to finance anywhere from 5% to 20% of the acquisition value. They usually offer terms similar to what your primary lender offers.

d) Common acquisition financing structure

Most of the small business acquisitions that we work with use SBA-backed financing. Furthermore, many buyers try to finance as much of the transaction as possible. Due to their structure, most of these transactions would qualify as small business leveraged buyouts.

Generally, the transaction has a 90% component financed through an SBA-backed loan. The remaining 10% comes from the equity injection and seller financing.

2. How much money do you need to buy a business?

A major challenge for new business buyers is determining how much money they need to buy the business. This important consideration requires careful financial planning.

Let's examine the total cost of an acquisition. This cost incorporates more than just the listed price of the business. It includes the following:

• Cost of the business
• Capital expenditure allocation (CAPEX)
• Working capital allocation
• Other expenses

The total cost of the acquisition is the amount that drives the transaction. The amount of money you need to acquire the business is based on the percentage you must contribute as an equity injection. This amount varies by lender and transaction. However, it is reasonable to assume that the equity injection is 10% to 20% of the total acquisition cost.

Keep in mind that your estimate of the equity injection size may change as the transaction moves forward. It can change as you perform due diligence, learn more about the business, and negotiate with the seller.

3. What to do before you look for a business

You can increase your chances of getting financing by doing a few things before looking for businesses. Here are the most important things you should do.

a) Check your personal credit and the credit of all your potential partners

Ideally, your credit score should be at least 650. Obviously, higher credit scores are better. Lenders, including SBA-backed providers, use your personal credit as a proxy for financial responsibility. We know this approach is not always accurate (nor necessarily fair), but this is how they do it.

b) Determine your net worth – personal assets and personal liabilities

Lenders need to know the net worth of you and your partners. Lenders want to see your assets, such as:

• Stocks
• Savings
• Home equity
• Investments

Additionally, you must show the lender your liabilities, such as your mortgage, car loans, and personal loans.

c) Gather the last three years of tax returns

The lender also asks you and your partners (those with 20% or more ownership share) to provide your complete tax returns for the last three years. To avoid delaying your loan, get your tax returns ahead of time. Speak with a tax professional if you need help in this area.

d) Start raising funds for the equity injection ("down payment")

In most traditional SBA-guaranteed loans, the borrower is expected to provide at least a 10% equity injection. As previously discussed, the equity injection can be reduced to 5% if you are also using seller financing and if the seller is willing to provide a standstill on their loan. Most lenders will not consider your acquisition if you cannot show that you have access to these funds.

This topic often brings up the issue of so-called "no-money-down acquisitions." For all intents and purposes, no lender makes loans for these acquisitions. At least, we have never seen one because lenders consider them too risky.

Some particular situations can require minimal money down, such as some very asset-rich leveraged buyouts. However, most transactions require a 10% to 20% down payment. You should be prepared for this cost.

4. When to start looking for financing

Buyers often make the mistake of looking for funding before they find their target business. While it's a good idea to interview potential lenders early on, lenders are not able to provide much information until you have a specific transaction you are working on.

a) Do you have a Letter of Intent (LOI)?

In most cases, buyers should apply for funding only when they are ready to submit a LOI for a specific transaction. A well-written LOI should have enough information to give prospective lenders a good overview of the transaction structure.

Think about the process in this way. Your financing is based on a specific business's acquisition value, proposed structure, track record, assets, and cash flow. Lenders need this information before they can discuss specific financing options.

b) A potential catch-22?

This situation can create a catch-22. Buyers don't want to make an offer without financing in place. However, lenders don't want to discuss financing without an executed LOI.

The solution is simple: make sure you have a well-written LOI. Remember that a well-written LOI has clauses that make the offer contingent on getting financing, among other important details. These clauses offer important protections. For this reason, it's a good idea to have a qualified attorney work with you to develop an LOI that protects your interests.

5. How to get the business acquisition loan (usually an SBA 7(a))

The most important thing you need before looking for financing is a signed LOI from the seller. While you should speak to some lenders before you get the letter, no one can give you a proposal unless you have the signed LOI. Here are the steps to get an acquisition loan:

Step 1: Select the provider you will work with

The market is competitive, and several providers offer SBA-guaranteed loans. While their requirements are similar, they also have important differences. Each provider has its own specific risk criteria. Select the loan and provider that works for you and that you are comfortable with.

Step 2: Get a prequalification for an SBA 7(a)

The next step is to get a loan prequalification for the transaction. In this step, the lender reviews the opportunity and determines if it meets the general requirements. Obtaining a prequalification does not guarantee funding. However, it shows that the transaction has a good chance of getting funded if all the final details check out.

Aside from the lender's application, you need to submit the following:

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

Getting this information ahead of time helps ensure you meet the deadlines defined in your letter of intent. You can find more detailed information on business acquisition loan requirements.

Step 3: Initial underwriting

The next step is for the lender to start its underwriting process. The length and depth of this process depend on the details of the business that you are acquiring. At this stage, the lender wants to ensure that the transaction meets its general criteria.

The lender reviews all the financial information in detail. Initial negotiations about add-backs usually happen at this point. These negotiations are critical because they affect the Seller's Discretionary Earnings, often used to calculate the acquisition price.

The lender also evaluates the buyer(s). This assessment includes a review of their relevant experience, assets, and liabilities. If all goes well, the lender issues a Prequalification Letter.

Step 4: Final qualification for an SBA 7(a)

The next step in the process is to get formal approval for funding. At this point, the team usually assembles a workbook with all the important details of the opportunity.

For example, the workbook could include:

• Transcripts of all tax returns (using an IRS 4506-T form). Note that any tax returns that don't match the transcripts must be restated.
• A copy of business liability insurance coverage
• Copies of all insurance that covers assets
• Payroll information and tax submissions
• Workers' compensation coverage
• Copies of bank and merchant account statements
• Copies of all notes and titles
• Copies of all leases (e.g., buildings, vehicles)
• A copy of the asset sale agreement or stock sale agreement

Once assembled, the workbook is submitted to the credit committee. The committee has the option to approve, reject, or request more information. Once the funding package is approved, the lender issues a formal approval letter.

Step 5: Schedule appraisals

The last step before funding is to schedule the appraisals. All company assets, such as machinery, equipment, and real estate, are appraised and reviewed. If the asset values come as expected and support the acquisition, the transaction moves to funding.

Step 6: Funding

The last step in the process is funding the loan. In this step, the lender's appointed escrow agent distributes funds, assets, and stock according to your agreements with the seller (an Asset Purchase Agreement or a Stock Purchase Agreement). After this step is completed, you formally own the business.

6. Conclusion

Financing a business acquisition can seem overwhelming for first-time business buyers. It's easy to encounter problems if you are unprepared or have unrealistic expectations about the transaction. Your best approach is to plan all the details ahead of time. Gather all the needed information before contacting potential lenders. Lastly, research all available options thoroughly. This transaction will likely be your most significant investment to date.

 

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.