As a buyer, you generally have three major sources of funds to consider: bank financing, seller financing, or your retirement funds. Money from investors and earnouts is less commonly used to finance a transaction.
- 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 taking a look at 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 is contingent on bank financing. Once the seller accepts the offer, they can assist you in obtaining the financing.
Bank Financing (SBA)
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 the buyer, which translates into more net income for the buyer.
SBA 7 (a) Loan Program
Nearly 95% of small business loans for the acquisition of a small business are made through the 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. The loan guaranty fee can be thought of as an insurance premium to cover the SBA’s losses in the event of a default.
SBA Loan Criteria for All Loan Types
- Maximum loan size: $5,000,000
- 10% to 30% equity injection (down payment)
- 640 credit score
- Industry and/or management experience preferred
SBA Loan Terms & Conditions
- Term loans with low-interest rates up to $5 million
- Working capital can be included in the loan amount
- No prepayment penalties on most loans
Seller financing is often the most suitable option if SBA financing cannot be obtained.
Benefits of Seller Financing
Seller financing is faster to arrange and requires less paperwork than traditional financing sources. With seller financing, you make a down payment on the business to the seller, then make monthly payments until the price is paid in full.
Seller Will Qualify You
Because the seller is functioning as a bank, you can expect the seller 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.
Most sellers want a minimum down payment of 50%, and many sellers offer terms ranging from three to seven years on the balance; however, the terms must make sense financially for both parties involved.
For example, if the purchase price is $1,000,000 and the seller is willing to finance 50% of the purchase price, you put down $500,000 and make monthly payments until the remaining balance of the seller note is paid in full.
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. We recommend providing the seller with a copy of your detailed financial statements, credit report, resume or C.V., and any other pertinent information on yourself as early in the process as possible. We also recommend that you offer the seller access to monthly or quarterly financial statements post-closing.
If you represent a company, document your previous acquisitions. Allowing the seller to talk to the owners of companies you have acquired in the past may also be helpful.
What interest rate is fair to offer the seller?
Over the previous 10 years, interest rates charged on promissory notes have ranged from 5% to 8%. The rate generally depends on the amount of risk involved and less on the current cost of money. Some buyers believe the rate on the note should be similar to current interest rates on residential real estate mortgages. However, such a loan is risky for the seller when little collateral is available other than the assets of the business.
Other factors that should be considered in determining the interest rate include the total price of the business, your credit score and financial position, your experience in running a business, and the amount of the down payment.
How do I know how much to finance?
Your decision regarding how much to finance must make sense from a cash-flow standpoint. If the business makes a profit of $100,000 per month, a note of $90,000 per month won’t make sense. The profit 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. If it can’t, it won’t work.
Statistics on Seller Financing
The following information on seller financing is based on statistics from more than 10,000 business sales (Source: Morgan & Westfield with data from BizComps):
- Average interest rate: Ranges from 5% to 8%
- Average length of note: Five years, but it varies from three to seven years
- Average down payment: 50%, but it varies from 30% to 80%
It’s best to offer specific terms when buying a business. This sends the message to the seller that you have carefully considered the terms and are serious and realistic. Sellers are more comfortable when dealing with a prepared buyer.
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 purchase the business, and the seller receives cash at closing. Because you’ll be buying stock as an investment in your own company, you don’t have to take a taxable distribution.
Creative use of financing has allowed us to finance million-dollar transactions with as little as $20,000 cash down. Through this process, you can invest in a business or franchise by utilizing existing retirement funds without taking a taxable distribution or getting a loan. This arrangement allows an individual 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 should not be ignored. In the absence of other forms of financing, bank financing is critical.
Retirement Funds Financing When Buying or Selling a Business
An earnout is a form of deferred payment to the seller that is contingent on certain events occurring post-closing in a manner that depends on the performance of the acquired company.
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. Very few sellers of small businesses are willing to accept an earnout, and we don’t recommend them for small businesses. They are notoriously difficult to administer and subject to many problems post-closing. Earnouts are generally only appropriate for mid-sized companies in which the seller remains to operate the business post-closing.
A last resort is to seek money from investors. Obviously, an investor is not going to hand over hundreds of thousands or millions of dollars without reviewing at least some information on your business. It will be critical that we communicate directly with any potential investors.
Investors Need to Sign an NDA
Your investors will not be willing to make an investment without obtaining information on the business, so they will also need to sign a non-disclosure agreement (NDA) for the business. Even though investors may wish to remain private, they will need to be vetted the same as any other potential buyer. We qualify anyone who receives information on a business and they must sign an NDA. All information gathered about a business and investors is handled with the strictest confidentiality.