Where the Money Comes From

The buyer’s personal equity is a key element in the acquisition of small and mid-sized businesses. Anywhere from 10% to 100% of the capital necessary to purchase a business comes from the buyer’s own cash injection. Most individual buyers of small businesses prefer to leverage their down payment – as a result, they prefer not to pay all cash. Some corporate acquirers put down larger amounts than individual buyers, although this varies significantly from company to company. So, where does the remainder of the cash come from?

There are three major components of deal structure: 

1. Seller Financing
2. Bank or SBA Financing
3. 401(k) Rollovers

Source 1: Seller Financing

The simplest way to finance the acquisition of a small business is for the buyer to work closely with the seller to negotiate a “seller note.” 

Seller financing is faster to arrange and requires less paperwork than traditional financing sources. Seller financing is often the most suitable option if SBA financing can’t be obtained. 

How does seller financing work? If the price of a business is $5 million and the seller is offering 50% financing, then the buyer would put down $2.5 million and make payments on the remainder until the note is paid in full. Nearly 85% of small business purchases involve seller financing. 

Sellers typically offer terms of three to five years and interest rates of 5% to 8%.

Advantages of Seller Financing:

• Less paperwork
• Less stringent requirements for buyers regarding things like their experience and credit
• Minimal closing costs
• Fast closing time
• Motivation to ensure the buyer is successful, which can make your business easier to sell

Disadvantages of Seller Financing:

• Risk of default
• Less cash at closing

Source 2: Bank or SBA Financing

Nearly 95% of bank loans for the acquisition of businesses under $5 million are Small Business Administration (SBA) loans. The maximum loan size for an SBA 7(a) loan is $5 million. Loans above $5 million are primarily conventional loans. If a corporate buyer is purchasing your business and the loan size is likely to exceed $5 million, the buyer will pursue traditional sources of financing other than an SBA loan. The SBA 7(a) loan is the number one source of financing for acquisitions of businesses under $5 million, other than seller financing.

To be clear, the SBA does not actually loan money. The SBA, through its 7(a) Loan Program, helps small businesses access credit by guaranteeing loans made by banks. This limits risk for banks offering such loans, which encourages them to lend money to small businesses. By doing this, SBA financing can offer buyers attractive loan terms and interest rates while eliminating, or reducing, the need for the seller to carry a note. 

For the buyer, this means a lower down payment, lower debt service, and higher net income. Because this is a government-sponsored program, there are strict guidelines that any bank must follow when offering an SBA loan.

SBA financing can also sometimes be combined with seller financing.

Advantages of SBA Financing:

• There is a lower down payment requirement for buyers, typically 10% to 20% cash. This can improve the chances of selling your business because there are more buyers with 10% to 20% cash down than buyers with 50% or more cash down.
• An SBA loan will have a longer amortization period – typically 10 years. This results in lower monthly payments, which increases cash flow for the buyer and makes your business easier to sell.
• SBA financing can be combined with other forms of financing, such as seller financing and 401(k) rollovers.
• As the seller, you receive cash at closing, which reduces your risk.

Disadvantages of SBA Financing:

• There is more loan paperwork required.
• There is a longer approval and closing time frame.
• There is a lower success rate of obtaining SBA financing vs. seller financing.
• There are more stringent requirements and guidelines, which reduce the likelihood of SBA approval.
• Most SBA loans require a business appraisal. The loan may be denied if the appraised value is less than your asking price.
• There are higher closing costs for the buyer, typically 3.5% to 4%, which is regulated by the SBA. This may reduce the total purchase price the buyer can pay for your business.
• There is normally a variable interest rate for the buyer, which increases risk for the buyer and therefore the price they can pay you for the business.

Source 3: 401(k) Rollovers

A buyer can also avoid taking out a small business loan altogether and use their retirement funds to finance a new business purchase. Since buying stock will be an investment in the buyer’s own company, they won’t have to take a taxable distribution. Creative use of this form of financing has allowed us to finance million-dollar transactions with as little as $20,000 cash down. While numerous qualifications exist, retirement plans should be fully accessible and should be enabled to be rolled over into another plan. 

If done right, there are no penalties for the buyer when using a 401(k) or IRA to buy a business.

Advantages of 401(k) Rollovers:

• You receive cash at closing, which reduces your risk.
• There is a high success rate of obtaining funding, which reduces your risk of a buyer not obtaining financing.
• Interest on the debt is tax-deductible for the buyer, making the transaction more attractive.

Disadvantages of 401(k) Rollovers:

• Using retirement funds results in a longer time frame to work out the details.
• An annual appraisal may be required, which would be paid by the buyer.
• There may be ongoing maintenance fees, which are paid by the buyer.

Common Transaction Structures

A buyer can combine all three forms of financing to purchase your business. I have outlined a few common transaction structures below and broken these down into three broad categories: all cash, seller financing, and bank (SBA) financing. A 401(k) rollover is included as cash in these example transaction structures and counts as the buyer’s personal equity, and can also be used in combination with seller or bank financing.

The following are the most common transaction structures for businesses sold to individuals and priced under $5 million:

• All Cash
  • Buyer pays 100% cash at closing 
• Seller Financing
  • Buyer puts 50% cash down 
  • You finance 50% of the purchase price 
• Bank or SBA Financing
  • The buyer puts 20% cash down 
  • The buyer obtains an SBA loan for 80% of the purchase price
• Hybrid
  • Buyer puts 10% cash down 
  • Seller finances 10% of the purchase price
  • The buyer obtains an SBA loan for 80% of the purchase price

I recommend considering your financing options in the following order:

1. SBA Financing: First, consider SBA financing, which offers the most lenient terms, including the lowest down payment and the longest amortization period.
2. Seller Financing: Consider seller financing if SBA financing is not available or if you prefer to offer seller financing due to other reasons such as tax benefits.

If your business is priced from $5 million to $10 million, it will most likely be sold to a corporate buyer who will typically put down 70% to 90% of the purchase price and you will finance the remaining 10% to 30%. The buyer will obtain their own financing and in most cases will require that 10% of the purchase price be held in escrow for a period of 12 to 18 months before it is released to you. These buyers also sometimes propose an earnout as part of the transaction structure. Earnouts will be covered in later chapters.