Note: If you represent an institutional buyer, such as a corporate acquirer, private equity firm, or family office, you will likely arrange your own financing. This section is therefore only applicable to individuals and smaller companies who are purchasing a company valued at less than $5 million.
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.
- We recommend first considering Small Business Administration (SBA) financing, which is obtained through banks and which offers the most lenient terms.
- If SBA financing is not available, we recommend considering seller financing.
- 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. The seller will not want you shopping their business without their knowledge or consent. An offer can be made that’s contingent on bank financing, and the seller can then provide you with all the documents you require to obtain approval if they accept your offer.
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 that 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
- 10% to 30% cash equity injection (down payment)
- 640+ credit score
- Industry or management experience is preferred
SBA Loan Terms & Conditions
- Working capital can be included in the loan amount
- No prepayment penalties are assessed on most loans
Seller financing is often the most suitable option if SBA financing can’t be obtained.
Benefits of Seller Financing
Seller financing is faster to arrange and requires less paperwork than third-party financing sources. With seller financing, 50% cash down is typically required, then monthly payments are made until the price is paid in full.
Because the seller is functioning as a bank, you can expect them to pre-qualify 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 cooperation of the seller.
Most sellers desire a minimum down payment of 50%, and many offer terms ranging from three to seven years on the balance. The terms must work for both 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 what information you’re comfortable providing, with proof of your liquidity,3 at a minimum.
- If you represent a corporate acquirer, document 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
Over the previous 10 years, interest rates on promissory notes have ranged from 5% to 8%. Although, the rate generally depends on the 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 Down Payment
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 is too low. The profit generated from the business must cover the amount of the note, pay you a living wage, and provide a cushion in the event of a downturn.
Offer Specific Terms
It’s best to offer specific terms when buying a business. This sends the message to the seller that you’ve carefully considered the terms and are serious and realistic.
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 an individual to invest up to 100% of their 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.
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.
A last resort is to seek money from investors. Your investors will not be willing to make an investment 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 will need to be vetted the same as any other potential buyer. We are 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.