7: Arrange Financing
Note: This section is most applicable to individuals and smaller companies.
If you’re an individual or represent a smaller company, you generally have three major sources of funds to finance the acquisition: bank financing, seller financing, or your retirement funds:
- Source #1: We recommend first considering Small Business Administration (SBA) financing, which is obtained through banks and which offers the most lenient terms.
- Source #2: If SBA financing is not available, we recommend considering seller financing.
- Source #3: Your retirement funds can be used in combination with seller or bank financing.
Note: You should first receive permission from the seller before sharing their confidential information with third parties, such as lenders. The seller will not want you shopping their business without their knowledge or consent. An offer can be made that’s contingent on third-party (e.g., bank) financing, and the seller can then provide you with all the documents you for for approval if they accept your offer.
Bank Financing
Approximately 95% of small business loans for the acquisition of a small business are made through the SBA 7(a) Loan Program. SBA financing offers buyers 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.
SBA 7(a) Loan Program
Because this is a government-sponsored program, there are strict guidelines any bank must follow when offering an SBA loan. The buyer must also pay a loan guaranty fee when obtaining an SBA loan, which supports the program.
SBA Loan Criteria for All Loan Types
- Maximum loan size: $5,000,000
- Equity injection/cash down payment: 10% to 30%
- Credit score: 640+
- Experience: Industry or management experience is strongly preferred by most lenders
SBA Loan Terms & Conditions
- Working capital: Working capital can be included in the loan amount.
- Prepayment penalties: No prepayment penalties 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
Note that we often include a clause in a letter of intent (LOI) that obligates the buyer to meet certain milestones during the due diligence period. Two of the key milestones are providing (1) a term sheet and (2) a commitment letter.
The high-level overview for obtaining an SBA 7(a) loan is as follows:
1. Prequalification Letter
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. Many lenders can provide a prequalification letter after meeting an applicant once. Because it is not legally binding, the prequalification letter does not carry much weight and generally won’t be used to guarantee anything.
2. Provide Documents
Your next steps are to ask the lender what documents they require (e.g., tax returns, bank statements, etc.) from the business you are acquiring. Once you have the list of documents, you should send it to us so we can begin organizing the information the lender needs to begin the loan process.
3. Lender Term Sheet
A term sheet contains a detailed list of the terms under which the lender may grant the loan. The purpose of the term sheet is to lay out the terms and conditions of the loan based on the documents you have provided. Most lenders can provide a term sheet of 3 to 8 pages within 1 to 3 weeks of receiving all documents they need. While a lender term sheet is not a binding commitment, it does demonstrate to us and the seller that progress is being made towards receiving financing.
To prevent delays in the sale process, we often require that the buyer meet certain milestones in the LOI for it to remain active. Two of these milestones are obtaining and sending us (1) a lender term sheet and (2) a commitment letter. Many buyers make the mistake of initiating the loan process only after due diligence is complete. This can be highly problematic, given how long the process is to obtain an SBA loan.
4. Commitment Letter
A commitment letter is a legally binding document from the lender committing to provide the loan subject to certain terms and conditions. It is often 5 to 10 pages in length. Most lenders can provide a commitment letter in 3 to 6 weeks after receiving the documents they need.
A commitment letter provides the seller with a significant level of confidence that you will obtain the loan, which encourages them to continue investing time and money in closing the transaction. Most sellers are only willing to continue investing time and money if they receive a copy of your commitment letter. Both parties must exhibit a certain level of trust in one another and the process to reach a successful outcome. A seller can’t wait to receive a commitment letter before allowing a buyer to perform due diligence, and a buyer can’t wait to apply for the loan until due diligence is complete. Ultimately, both parties must trust one another and move forward based on an uncertain outcome.
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 price is paid in full.
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 also 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% down payment and may offer terms ranging from three to seven years on the balance. The terms must work for all parties involved.
How can I motivate the seller to finance the sale? Because the seller is financing a portion of the sale, the seller will think and act like a bank. Therefore, we recommend the following:
- If you are an individual buyer, we recommend providing a copy of your detailed financial statements, credit report, resume or C.V., and any other pertinent information about yourself as early in the process as possible to demonstrate that you’re qualified.
- If you represent a search fund, we recommend providing a copy of your financial statements, credit report, resume or C.V., and background information on your investors. We recommend sharing information on any decision-makers 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, share the details of your previous acquisitions. Allowing the seller to talk to the owners of companies you have acquired in the past may also be helpful.
The Interest Rate: Interest rates on promissory notes have historically ranged from 5% to 8%. 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. 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. If the business generates $500,000 per month in profits, a note of $450,000 per month won’t work because the debt-coverage ratio will be too low. The profit generated from the business must cover the amount of the note, pay you a salary, and provide a cushion in the event of a downturn.
Offer Specific Terms: It’s best to offer specific terms when buying 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.
Retirement Funds
Retirement funds can be accessed quickly and with a high success rate, whereas bank financing is often difficult to access.
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. Through this process, you can invest in a business by utilizing your existing retirement funds without taking a taxable distribution or obtaining third-party financing. 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 to both the buyer and the seller of a business, bank financing shouldn’t be ignored. In the absence of other forms of financing, bank financing is critical.
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 employees or the issuance of a patent.
Not Recommended for Small Businesses: Earnouts are rare in smaller 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 are 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 negotiations of the LOI, reduce your transaction costs as your professional advisors (e.g., accountant, attorney) will be able to quickly understand your earnout, and simplify administration of the earnout after the closing.
- Prepare a Sample Calculation: Prepare a spreadsheet with multiple sample calculations (e.g., low, medium, high) with real scenarios so all parties are 100% clear on how the earnout will function. We commonly receive earnouts that appear to be straightforward on the surface but actually 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 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.
Investors
A last resort is to seek money from investors. Your investors will not be willing to invest without obtaining information on the business, so they’ll also be required to sign a non-disclosure agreement (NDA). 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 everyone 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 have begun due diligence because lenders require access to confidential information on the business, such as tax returns. However, you can speak with lenders to prequalify yourself for a business prior to submitting an offer.