Summary: Buying an established business is a common way for first-time entrepreneurs to get into business ownership. It's a strategy that has lower risk because buyers can review past performance and, consequently, be better able to forecast performance. When executed correctly, this strategy can help the buyer acquire a company with solid potential.

However, buying a business requires funds to pay for the acquisition. This requirement presents a challenge for many first-time buyers who don't have a lot of resources. In this article, we cover:

1. How are companies purchased?
2. How are acquisitions financed?
3. How are LBO transactions structured?
4. Why do I need to contribute an equity injection?
5. How much money do you need to buy a business?
6. When to look for financing

1. How are businesses purchased?

Most entrepreneurs who buy established companies choose to finance their acquisition. This is because most buyers don't have the resources to pay for an "all-cash" acquisition. Actually, even those that do have the funds still prefer to use financing because of its perceived advantages.

A transaction that uses a substantial portion of financing is called a leveraged buyout (LBO). Most small business acquisitions use an LBO structure because of its low equity requirements. An LBO allows buyers to finance up to 90% of the transaction while contributing only 10% as an equity injection.

2. How are small business acquisitions financed?

The type of financing you can obtain varies with the size and complexity of the transaction. This article focuses on small business leveraged buyouts, which have an acquisition price of less than $5,000,000. Most small LBOs use a combination of four financing sources:

a) Buyer's equity injection

All acquisitions require buyers to contribute some funds to the purchase. Leveraged buyouts enable you to contribute the lowest amount, which is 10% of the project value. The buyer's contribution is called an equity injection and cannot be financed or come from the seller. It must come from the buyer or their partners. Learn more about equity injection sources.

Unfortunately, the popular business press has giving LBOs the reputation as a way to finance acquisitions without using your own funds. This may be true for large transactions that use institutional financing. However, it is not true for most small leveraged buyouts. You can learn more by reading "Can you do a leveraged buyout with no money down?"

b) Seller financing

Many transactions also have a component that the seller finances. Most sellers would prefer to get paid immediately. However, buyers often demand seller financing because it shows that the seller stands behind their business. Most sellers are willing to finance some part of the transaction, usually between 5% and 20% of the value. Terms are negotiable and are typically competitive.

c) SBA-backed loan

The Small Business Administration (SBA) helps finance most small business acquisitions. The SBA does not provide loans directly. Instead, it gives a guarantee to lenders, which offers them some protection against losses. The guarantee serves as an incentive for lenders to finance smaller acquisitions.

The role of the SBA is to help small businesses. Their loans are known for being flexible, affordable, and easier to obtain than other options. Keep in mind that getting an acquisition loan requires preparation and effort. There are no "simple" or "easy" loans. To learn more, read "How to get a loan to buy a business."

d) Non-SBA-backed loan

Conventional lenders also finance acquisitions. These loans are helpful in transactions that don't qualify for SBA-backed financing. Most traditional lenders have higher collateral requirements and more stringent qualification criteria than their non-SBA counterparts.

3. How are LBO transactions structured?

Although each transaction is different, most of the acquisitions we see use a combination of these three options:

1. Buyer's equity injection
2. Seller financing
3. SBA-backed loan

Every transaction has an equity injection contribution from the buyer. The minimum amount you can contribute is 10% of the acquisition value. However, many transactions user higher contributions of 20% to 30%.

Seller financing is also present in most transactions. This segment covers 5% to 20% of the transaction's value. Lender financing, usually with an SBA-backed loan, covers the remaining portion that is not covered by seller financing or the equity injection.

4. Why are equity injections required?

Buyers often wonder why equity injections are required. Their concern is understandable since they often have to use all their savings to pay for it. Lenders require the buyer's contribution because it:

a) Shows the buyer's commitment

Buyers who use their personal resources for a transaction are committed to it. They will stay with the business through good and bad times to ensure the success of the enterprise. This commitment is important for lenders.

Let's look at the opposite side of the coin. Assume a buyer finances an acquisition but contributes no equity. What is their incentive to stay with the business if things don't go well and the company drops in value? Unfortunately, experience shows that many buyers who don't contribute equity to the acquisition simply "walk away" from the business when things don't go well. They let the lender handle the consequences. As you can imagine, lenders don't want to find themselves in that position.

b) Protects lenders against drops in value

The equity injection provides a cushion of protection to the lender. It protects the lender's principal against a drop in the value of the acquired company.

c) Covers valuation differences

Equity injections are also used to cover valuation differences between the seller, the buyer, and the lender. These situations occur when the lender has a lower valuation than the buyer and seller. When this happens, the buyer must contribute additional equity to bridge the valuation gap.

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

Buyers are ultimately trying to figure out how much money they need to buy a business. Consequently, they need to determine the size of their equity injection.

The size of the equity injection is based on the total project cost, which includes a number of line-items. The total project cost usually includes:

1. The company's acquisition cost
2. Financing for capital expenditures (if any)
3. Financing for working capital (if any)
4. Closing costs

The minimum equity injection is 10% of the sum of the values listed above. Note that it is not 10% of the value of the loan. This is a common misunderstanding among buyers. As you can see, the value of the loan does not figure in that calculation.

6. When to look for financing?

In our experience, most buyers look for financing too early in the process. This sounds counterintuitive to buyers until they understand how lenders operate.

Most finance companies will not consider a transaction until the seller has accepted a Letter of Intent (LOI) from the buyer. The LOI contains all the details of the transaction, which are critical to structuring a financial package. The lender uses the information in the LOI to structure a financing package. There is little a finance company can do without those details.

Buyers are usually concerned about submitting an LOI before securing financing. Most well-written LOIs have a clause that advises sellers that the offer is contingent on finding appropriate funding. Due to the complexity of acquisitions, consider working with a seasoned attorney when crafting your LOI.

Want to finance a business acquisition?

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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.