Buyers have numerous potential sources of funds when it comes to purchasing a business. A smart buyer considers all the options. Your CPA or CFO can assist in the analysis and also guide you as to how various funding methods may improve your tax situation. Here is a quick review of various common funding methods. Your individual circumstances will dictate which is the right solution for you.
Buyer’s Personal Financing
The first thing to consider is your available funds and the amount you are truly comfortable with. I often explain to Buyers that it’s not like buying a house. Residential real estate brokers can often be heard suggesting that Buyers “stretch it…. over the next thirty years it’s only an extra $65 a month. “
But when it comes to buying a business over stretching is a sin. Buyer’s often forget that all businesses require working capital to operate the business and backup funds for unexpected situations over the years. That’s why I used the word “comfortable” in the paragraph above. You also don’t want to stretch so far that you can’t sleep at night worrying about the next payroll.
Of course, if you are an established business seeking to acquire another company this issue may not be as critical, but still deserves attention.
In most cases that I see, buyers should be prepared to invest 15 to 50 percent of the amount needed to purchase a business. This amount varies based on your individual situation and your own individual risk tolerance. Some buyers are what I call CD buyers and others are stock buyers. In other words, a CD buyer tends to be conservative when it comes to risk and stock buyers are more apt to take more significant risks. Both are reasonable positions, you just need to honestly evaluate which category you fit into before starting your acquisition search.
Generally speaking the higher the amount of your down payment the more attractive you are as a buyer to a Seller who you are asking to finance a portion of the purchase price, and a lender who likes to see that you have money at risk too.
Put bluntly, I recommend that buyer purchase a business without having the seller provide a portion of the financing. Why? Three reasons:
- You want a Seller to have skin in the game. In other words, you want the Seller to be motivated to help you once the business is sold. There is no better way I know of to incentivize a Seller to help you then for them to be hold a promissory note for a portion of the purchase price.
- In the unlikely event that there is a problem post closing, or the Seller failed to accurately represent the financial condition of the company, you may be able to offset those costs against the promissory note.
- Lenders like, and sometimes require, that the Seller hold a promissory note to give that lender additional confidence.
How large the promissory note needs to be depends heavily on the individual circumstances relating to the business. There is no cookie-cutter answer. In some instances I have seen the Seller finance up to 50 to 60% of the purchase price, while in others it has been 10%.
Venture Capital & Investment Bankers
In most cases this level of fundraising is for mid to large size businesses. We have worked with many Private Equity Groups, Investment Bankers and small investment funds.
If the business you are seeking to acquire is generating $1 million in annual earnings then this option may be a possibility for you.
In many instances this level of investor will expect to hold equity in the company.
Small Business Administration (SBA Loans)
The Small Business Administration Loan Guarantee Program (SBA) is the #1 source of small business acquisition financing in the United States. Despite many people’s impression that the SBA issues loans, the SBA does not issue loans, they simply provide a Guarantee to participating banks and lenders – essentially providing insurance for the bank or lender should a buyer ever default on the business acquisition loan.
SBA loans can be for as long as ten years (longer if a building is included in the sale) and provided up to 80% of the purchase price . The advantages of an SBA loan are:
- Because the SBA provides a guarantee of payment to the lender SBA loans are “easier” to obtain than convention bank loans, especially in bad economic times.
- Longer term payout (up to ten years or more) thus lowering your monthly payments, compared to many conventional bank loans
- Loans may include working capital, equipment, machinery and real estate. There are minimum and maximums on the size of SBA loans depending on the actions of Congress. As of this writing the minimum was $100,000 and the maximum $5,000,000.
Like any bank loan, issuance of an SBA loan is subject to the lenders review of the stability of the business, collateral, the credit history of the buyer and many other factors.
We work with many different lenders and can help provide you with introductions to many SBA lenders. Always keep in mind that many of the fees and points charged by lenders are negotiable, so always talk to more than one lender and compare rates and fees.
We often hear people complain that “Oh, I’ve heard that SBA loans are a nightmare”. In my experience, if a borrower follows the SBA rules and the lenders requirements and does their homework in advance the process is no more difficult than conventional bank financing.
Conventional Financing & Lines of Credit
During the economic downturn banks virtually stopped issuing conventional loans and, pushed buyers towards SBA funding. Why? Because the banks wanted to reduce their loan risk and since the SBA program lowered their risk since the SBA guaranteed a portion of the loan their risk was therefore lower.
But today banks have begun loaning again. Therefore, buyers should not rule out the possibility of a non-sba bank loan since the rates and fees may be lower than an SBA loan. Again, we can help provide suggestions on banks to interview.
However, Buyers should be aware that banks tend to be more restrictive, expect higher collateral and overall, want a higher degree of comfort in the quality of the business you are purchasing and your own credit history.
Retirement Account IRA/401k Financing
A program exists that allows buyers to invest all, or a portion, of their retirements funds into the purchase of a business. The program allows you to invest your funds from an eligible retirement account into a small business without taking a taxable distribution or penalty from your existing IRA/401k. While IO have seen numerous buyers use this program to purchase a business, and there are several financial companies that will walk buyers through the process, I always recommend that buyers considering this program talk to their CPA before proceeding. Also, risking your retirement income on the purchase of a business is, well, risky. If you decide to consider this route, I can refer you to several companies that can assist you with setting up this program, which requires following a very strict set up rules and regulations.
“Buyers often hear stories from people about how difficult it is to get an SBA loan. In most cases that’s because the Buyer failed to follow the rules and plan ahead. The process is not that complicated or difficult if you do it right”