In this article, we discuss the process of getting a loan to acquire an existing business. We review the basics of a business acquisition loan – what you need to have in place before you apply, how to get the process started, and what to expect. The article covers:
- How are business acquisitions financed?
- How much money do you need to buy a business?
- When should you start looking for financing?
- What to do before you look for a loan
- How to get a business acquisition loan
- Conclusion and final words
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?
Few buyers can buy an existing business and pay for the acquisition cost in cash. Instead, most companies are purchased using a combination of lender financing, seller financing, and buyer’s cash. In this section, we explore these options in more detail.
a) Seller financing
Seller financing is an important component of many small business acquisitions. Buyers usually insist that sellers finance a portion of the acquisition. By offering financing, the seller becomes tied to the business for a few years after the purchase. This strategy helps ensure that sellers don’t exaggerate the performance potential of the business prior to the sale.
Keep in mind that sellers don’t want to offer financing to their buyers. They would prefer to get paid immediately. However, they have to offer financing because buyers demand it as a condition for the acquisition. They have no other choice. In our experience, sellers finance anywhere from 5% to 20% of the acquisition value. In most cases, sellers offer competitive terms that are similar to lender terms.
b) Lender financing
Most commercial banks are reluctant to offer loans to entrepreneurs who want to buy a business. The reason for this reluctance is that business acquisitions have a high risk. Consequently, banks only provide conventional acquisition financing to buyers with substantial assets that can be used as collateral for the purchase. As you can imagine, most buyers can’t meet the bank’s criteria.
This is where Small Business Administration (SBA)-backed lenders come in. The SBA works with specialized lenders that provide financing for small business acquisitions. This program provides buyers with access to competitively priced financing. Often, SBA financing is the buyer’s only viable alternative.
The SBA works by providing guarantees to their lenders. These guarantees reduce the lender’s risk, which provides an incentive to make otherwise “risky” loans. However, SBA guarantees are often misunderstood by business buyers. The SBA guarantee is considered a last resort as far as collections are concerned. In the event of default, lenders first try to collect from the business and the borrower. The lender can collect on the SBA guarantee only if the other efforts fail.
SBA-backed loans never cover 100% of the acquisition. They can usually cover up to 90% of the transaction value, depending on the details. Buyers are always required to contribute equity to an acquisition. This equity injection helps ensure that buyers have a financial participation in the acquisition.
c) Buyer’s equity injection
Lenders require that buyers contribute a minimum of 10% of the transaction price as an equity injection. This amount cannot be financed and cannot come from seller financing. The equity injection must come from the buyers. Here is more information about equity injection sources.
d) Common acquisition financing structure
Most of the small business acquisitions that we work with that use SBA-backed financing qualify as a small business leveraged buyout. These acquisitions use a mix of SBA-backed financing, seller financing, and a minimum 10% equity injection. We consider this to be the most common platform for small business acquisitions.
2. How much money do you need to buy a business?
Determining how much money you need to buy a business requires planning. As discussed in the previous section, most buyers finance their acquisitions. Thus, when buyers ask about the amount of money needed to buy the company, they refer to the size of their cash contribution (i.e., the size of the equity injection).
Your estimate of the equity injection size can change as the transaction moves forward. It can change as you perform due diligence, learn more about the business, and negotiate with the seller. Ultimately, the size of the equity injection is based on the final “total cost” of the project. You can estimate the “total project cost” by adding these figures:
- Cost of the business
- Capital expenditure allocation
- Working capital allocation
- Other expenses
The equity injection should be 10% to 20% of this project cost, depending on what you negotiate with the lender. This figure is the amount of money you need to acquire the business.
3. When should you start looking for financing?
In most cases, buyers should look for funding only when they have found the business they want to acquire and are ready to submit a Letter of Intent (LOI). Buyers often make the mistake of looking for funding before they find their target business. This is too early in the process and is usually counterproductive.
Think about the process in this way. Every financing offer is based on the acquisition value, proposed structure, track record, assets, and cash flow of a specific business. Without this information, lenders are not able to give you any useful figures. At best, they can speculate, which never helps.
This situation can create a catch-22. Buyers don’t want to make an offer without financing in place, but 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. This is why it’s a good idea to have a qualified attorney work with you to develop an LOI that protects your interests.
4. What to do before you look for a business
One simple way to improve your chances of success is to be prepared ahead of time. 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 scores should be at least 650. Obviously, higher credit scores are better. Lenders, including SBA-backed providers, use your credit as a proxy for financial responsibility. We know it is not always accurate (nor is it 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. You need to show the lender your personal assets such as stocks, savings, home equity, retirement savings, etc. Additionally, you need to 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 will also ask you and your partners (those with 20% or more ownership share) to provide your complete tax returns for the last three years. Since you don’t want your loan to be delayed, get your tax returns ahead of time. If you don’t have them, speak with a tax professional.
d) Start raising funds for the equity injection (“down payment”)
In most traditional SBA-guaranteed loans, the borrower is expected to provide at least 10% of the acquisition cost as an equity injection. This number 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 look at 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. There are some very specific situations that 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.
5. How to get the business acquisition loan (usually an SBA 7(a))
The most important thing you need before you can start looking for financing is a signed Letter of Intent from the seller. While you should certainly speak to some lenders before you get the letter, no one will 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
Your first step is to select the lending provider to work with. 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 prequalification for the transaction. In this step, the lender reviews the opportunity and determines if it meets the general requirements. Note that 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.
This step can be relatively simple or extremely hard, depending on how much preparation you had ahead of time. If you did all the preparations suggested in the previous section, this step should be straightforward. 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 saves you a lot of headaches and 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, which is often used to calculate the acquisition price. The lender also evaluates the buyer(s). This 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 may have to be restated.
- A copy of business liability insurance coverage
- Copies of all insurance that covers assets
- Payroll information and tax submissions
- Workman’s 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 they 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 the agreements you have with the seller (an Asset Purchase Agreement or a Stock Purchase Agreement). After this step is completed, you formally own the business.
6. Conclusion and final words
Financing a business acquisition can seem like an overwhelming process for first-time business buyers. It’s easy to encounter problems if you are not well prepared or have unrealistic expectations about the transaction. Fortunately, you can avoid most issues if you prepare ahead of time and work with partners that have experience financing acquisitions and leveraged buyouts.
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.