8: Arrange Financing

Note: This section is primarily applicable to individuals and smaller companies.

Summary of the Methods to Capitalize an Acquisition

A) Cash
B) Retirement funds
C) SBA (bank) financing
D) Seller financing
E) Investor capital
F) Earnouts

You should arrange financing simultaneously while you’re conducting due diligence. One of the most common mistakes is for buyers to wait to apply for a loan until after the due diligence period has been completed. This is a serious mistake as the loan process can often take two to three months, and many sellers back out of the process altogether if the process is delayed. While many lenders state the process may take as little as six weeks to complete, this is often a best-case scenario. In our experience, the loan process commonly takes two to three months to complete fully. It’s essential this process begins immediately when due diligence begins.

The most common ways for an individual or smaller company to capitalize an acquisition include using cash, retirement funds, SBA (bank) financing, seller financing, investor capital, and earnouts. Each method includes key benefits and risks, which are outlined below to help you make the most informed decision.

Discover the various methods and considerations involved in securing financing for small business acquisitions.

A) Cash

The most common source of capital used to acquire a business is cash. In most seller-financed transactions, cash represents at least 50% of the total consideration. In third-party financed transactions, cash often represents 10% to 20% of the total consideration.

B) Retirement Funds

Retirement funds can be accessed quickly and with a high success rate, whereas bank financing is often difficult to access. Retirement funds are delivered to the seller in the form of cash from the buyer at closing and can be combined with any other method of financing the acquisition.

Benefits of Accessing Funds: Using your retirement funds creates a win-win situation – you can easily access funds to acquire a business, and the seller receives cash at closing. Because you’re investing in the stock of your own company, a taxable distribution isn’t required. This arrangement allows you to invest up to 100% of your eligible assets to finance a business debt-free.

Bank Financing Can Still be Used: Although retirement funds have several advantages for both the buyer and the seller of a business, bank financing shouldn’t be ignored. In the absence of other forms of financing, it is a helpful tool.

Learn about leveraging retirement funds as a strategic financing solution for purchasing or selling a business.

C) SBA (Bank) Financing

Approximately 95% of loans for the acquisition of a small business are made through the SBA 7(a) Loan Program. SBA financing offers attractive loan terms and interest rates while eliminating or reducing the need for the seller to carry a note. This means a lower down payment and lower debt service for you, which translates into higher net income. The SBA normally requires a 10% to 20% cash down payment.

SBA 7(a) Loan Program

SBA Loan Criteria for All Loan Types

• Maximum Loan Size: $5,000,000
• Cash Down Payment: 10% to 30%
• Credit Score: 640+
• Experience: Industry or management experience is preferred by most lenders

SBA Loan Terms & Conditions

• Working Capital: Working capital can be included in the loan amount
• Prepayment Penalties: No prepayment penalties are assessed on most loans

Explore the benefits of SBA financing for buying or selling a business, including a comprehensive guide, the versatility of SBA loans, and why they are an excellent choice for financing your business ventures.

The SBA Loan Process

To prevent delays in the sale process, we often require that the buyer meet certain milestones in the LOI for it to remain active. Three of these milestones are obtaining and sending us 1) a list of documents the lender requires, 2) a lender term sheet, and 3) a commitment letter. Many buyers make the mistake of initiating the loan process only after due diligence is complete. This can be problematic, given how long the process is to obtain an SBA loan.

The high-level overview for obtaining an SBA 7(a) loan is as follows:

1. Prequalification: In lending, the prequalification letter is an initial assessment from a lender estimating your ability to obtain a loan to acquire a business. This estimate is based on minimal information you provide, and many lenders can provide a prequalification letter after meeting an applicant only once. Because they can be easily obtained with little information, the prequalification letter doesn’t carry much weight with a seller.
2. Document Request: Your next step is to ask the lender what documents they require (e.g., tax returns, bank statements, etc.) to issue a term sheet for the business you’re acquiring. Once you have the list, please send it to us so we can begin uploading the information the lender needs to the data room so the lender can begin the loan process.
3. Lender Term Sheet: A lender term sheet contains a detailed list of the terms under which the lender may grant the loan and typically varies from 3 to 8 pages long. The purpose of the lender term sheet is to lay out the terms and conditions of the loan based on the documents they have received. Most lenders can provide a lender term sheet within 1 to 3 weeks of receiving all the documents they need. The term sheet must be issued by an individual on the loan or underwriting committee and not a salesperson. While a lender term sheet is not a binding commitment, it does demonstrate to us and the seller that progress is being made toward obtaining financing. Most lenders charge a $2,500 fee when you accept the term sheet. The $2,500 is customarily refundable, less expenses. If you’re working with a loan intermediary, they may charge a nominal fee (e.g., $1,000) that is often non-refundable once you accept the term sheet. However, some will apply the fee toward another acquisition if the transaction does not occur.
4. Commitment Letter: A commitment letter is a 5—to 10-page legally binding document issued by the lender committing to provide the loan, subject to certain terms and conditions. Most lenders can provide a commitment letter within 3 to 6 weeks of receiving the requested documents. A commitment letter provides the seller with a significant level of confidence that you’ll obtain the loan, which encourages them to continue investing time and money in closing the transaction.

The Importance of Using a Loan Intermediary

A loan intermediary is a specialist in obtaining financing. Loan intermediaries know which banks are aggressively dedicated to committing to SBA loans, and most do not charge any upfront fees for their expertise and to assist with the application. You should ideally work with a loan intermediary who specializes in SBA business acquisition loans, which is the SBA 7(a) Loan Program.

Advantages of Using a Loan Intermediary

• Most intermediaries have success rates of 90% to 95%.
• High success rate – most intermediaries have success rates of 90% to 95%.
• They’re your advocate in the process. They work to get the best deal and the most options for you.
• They work with multiple lenders and can offer a variety of finance options.
• Intermediaries need results in order to be compensated.
• An intermediary will assist in gathering all necessary documents, critiquing the loan application, and speeding up the process from application to commitment, improving the chances of securing a loan.
• An intermediary will review and critique the business plan, professionally prepare loan documents, develop realistic revenue projections, and help select a lender with guidelines capable of approving the loan.
• They speed up the process for faster loan commitment and closing.
• They improve the success rate by utilizing creativity in deal structuring and their relationships with aggressive national lenders.

D) Seller Financing

Seller financing is often the most suitable option if SBA financing can’t be obtained. With seller financing, 50% cash down is typically required, and then periodic (e.g., monthly) payments are made until the balance is paid in full. A smaller seller note (e.g., 10% of the purchase price) can also be combined with other forms of financing.

Benefits of Seller Financing: Seller financing is faster to arrange and requires less paperwork than third-party financing sources.

Your Qualifications: Because the seller is essentially functioning as a bank, expect them to underwrite (i.e., prequalify) you before committing to financing the sale. You may offer your personal assets as collateral, in addition to the assets of the business, to help secure the seller’s cooperation.

Down Payment: Most sellers require a minimum 50% cash down payment and may offer terms ranging from three to seven years on the balance.

The Interest Rate: Interest rates on promissory notes have historically ranged from 5% to 8%. The interest rate is usually fixed, which simplifies administration and reduces your risk. The rate generally depends on the down payment and amount of risk involved and less on the current cost of money. It’s best to compare the terms to other business loans that share a similar risk profile to determine an appropriate interest rate and not to other types of loans that are not similar, such as residential real estate mortgages. Other factors that should be considered in determining an appropriate interest rate include the total purchase price of the business, the down payment, your credit score and net worth, and your relevant industry experience.

The Debt Service Coverage Ratio: The business must generate enough cash flow to cover the debt service and pay you a living wage. If the business generates $100,000 per month in profits, a note of $95,000 per month won’t work because the debt-coverage ratio will be too low. The cash generated from the business must cover the debt service, pay you a market-rate salary, and provide a cushion in the event of a downturn.

Offer Specific Terms: It’s best to offer specific terms when submitting an offer on a business. For example, a $1 million note amortized over 48 months at 7% interest. This sends the message to the seller that you’ve carefully considered the terms and are serious and realistic. Submitting an offer with only the amount of the seller note ($5 million purchase price with $3 million cash at closing and a seller note for $2 million) and no terms will only serve to delay the process.

How can I motivate the seller to finance the sale? Because the seller is financing a portion of the sale, you should provide them with additional information on yourself. Therefore, we recommend the following:

• If you are an individual buyer, you can speed up this process considerably by providing us with your credit report, resume or C.V., personal financial statements (we recommend using SBA’s Personal Financial Statement Form 413), a bank statement showing proof of the cash down payment, and any other relevant information.
• If you represent a search fund, you can speed up this process considerably by providing us with your credit report, resume or C.V., personal financial statements (we recommend using SBA’s Personal Financial Statement Form 413), a bank statement showing proof of the cash down payment, and any other relevant information. We recommend sharing any letters of support or information from any investors who will be involved in the process.
• If you represent a family office, we recommend providing the information you’re comfortable providing, with proof of your liquidity, at a minimum.
• If you represent a corporate acquirer (strategic buyer, PE firm, independent sponsor, etc.), share the details of your previous acquisitions. It may also be helpful to allow the seller to talk to the owners of companies you have acquired in the past.

E) Earnouts

An earnout is a form of deferred payment to the seller that’s contingent on certain events occurring post-closing.

Metrics for an Earnout: An earnout can be tied to revenue, EBITDA, or a non-financial metric such as retention of key employee retention or the issuance of a patent.

Not Recommended for Small Businesses: Earnouts are rare in small transactions but common in mid-market deals. Few sellers of small businesses are willing to accept an earnout, and we don’t recommend them for smaller transactions due to their inherent complexity. They’re notoriously difficult to administer and subject to numerous complications post-closing. Earnouts are generally only appropriate for mid-sized companies.

Tips for Proposing an Earnout: If you do propose an earnout, we recommend the following:

• Keep it Simple: Keep the earnout calculations as simple as possible. For example, an earnout based on revenue is much easier to negotiate and administer than an earnout based on earnings. This will help streamline the LOI negotiations and reduce your transaction costs, as your professional advisors (e.g., accountant, attorney) will be able to quickly understand your earnout, and administration of the earnout will be simplified after the closing.
• Prepare a Sample Calculation: Prepare a spreadsheet with multiple sample calculations (e.g., low, medium, high) and scenarios so all parties are 100% clear on how the earnout will function. Your spreadsheet should have the input cells clearly identified so the seller can run multiple scenarios to help facilitate a decision. We commonly receive earnouts that appear to be straightforward on the surface but contain numerous inconsistencies that can cause misunderstandings throughout the sale process. This commonly happens after the LOI is accepted and during the due diligence period. These inconsistencies are often uncovered by attorneys, accountants, or other parties and commonly result in renegotiations or the deal stalling or dying. This spreadsheet also helps to streamline the seller’s decision as to whether to accept the earnout. If the earnout is complicated, the seller often delays their decision until they understand it.

Gain comprehensive insights into the utilization of earnouts in both selling and buying businesses with our complete guide.

F) Investor Capital

Your investors will not be willing to invest without obtaining information on the business, so they may be required to sign a non-disclosure agreement (NDA) and buyer profile. Even though investors may wish to remain private, they’ll need to be vetted the same as any other potential buyer. We’re professionally obligated to qualify anyone who receives sensitive information on a business, and all information gathered about a business and investors is handled with the strictest confidentiality. Note that search funds tend to follow a different approach that may allow them to bind their investors to the NDA they execute.

Frequently Asked Questions

Should I arrange financing before I submit an LOI? Financing can only be explored in full after an offer is accepted and you’ve begun due diligence because lenders require access to confidential information on a business to underwrite it, such as tax returns. However, you can speak with lenders to prequalify yourself for a business prior to submitting an offer.