Small Business Acquisition Financing

Executive Summary

• How do most buyers finance the purchase of a business?
• How much cash down do buyers usually put on a business?
• How common is it for a seller to carry a note? If they do, what are the typical terms of a seller note?
• How common are bank loans to purchase a business?
• Are most bank loans an SBA loan?
• How can buyers use retirement funds to purchase a business?
• What are some typical transaction structures?

Read on as we explain the primary sources of financing buyers use to purchase small businesses. There are four major sources of funds:

• Buyer’s personal equity
• Seller financing
• Bank or Small Business Administration (SBA) Financing
• 401(k) Rollovers

In the following article, we examine each source of financing in more detail, including the advantages and disadvantages of each and how different forms of financing can be combined into some common transaction structures.

Note: This article applies only to businesses valued at $5 million or less. In larger transactions, companies use alternative sources of financing to finance acquisitions.

Buyer’s Personal Equity

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 needed to purchase a business comes from the buyer’s own cash injection. Most buyers of small businesses prefer to leverage their down payment — as a result, they prefer not to pay all cash when acquiring a business.

Seller Financing

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

The terms offered by sellers are usually more flexible and more agreeable to the buyer than the terms offered by a third party, such as a bank.

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

How does seller financing work? If the price of a business is $5,000,000 and the seller is offering 50% financing, then the new buyer would put down $2,500,000 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 seven years and interest rates of 5% to 8%.

Advantages

• Less paperwork required
• Less stringent requirements — experience, credit, etc.
• Minimal closing costs
• Fast closing time
• Seller is motivated to ensure the buyer is successful

Disadvantages

• Shorter amortization period (typically three to seven years)
• Requires a higher down payment, generally at least 50%
• Not all sellers are open to seller financing

Bank or SBA Financing

Nearly 95% of bank loans for the acquisition of a small business are Small Business Administration (SBA) loans. 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 in the event of a default. 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 highly formal guidelines that any bank must follow when offering an SBA loan. A small fee is involved when procuring a 7(a) loan, which helps to support the program.

SBA financing can also sometimes be combined with seller financing.

Advantages

• Lower down payment required (typically 10% to 20% cash)
• Longer amortization period (typically 10 years)
• Lower monthly payment (due to the longer amortization period)
• Can be combined with other forms of financing, such as seller financing and 401 (k) rollovers
• The seller receives cash at closing, which can increase your negotiating leverage

Disadvantages

• More paperwork
• More stringent requirements and guidelines
• Normally a variable interest rate
• Higher closing costs (3.5% to 4%, which is regulated by the SBA)
• Longer timeframe
• Most SBA loans require a business appraisal
• Lower success rate of obtaining SBA financing vs. seller financing

Related Resource: M&A Talk Podcast — Bruce Marks on SBA Loans for M&A Transactions — If you are buying or selling a business that involves an SBA loan, this show is for you. We spend over 90 minutes discussing the many facets of SBA loans, dispelling many of the most common myths along the way. Learn the differences between SBA and conventional loans, how the value of a business affects the loan, how SBA guarantees work, the requirements for obtaining a loan, how transactions are structured with an SBA loan, and much, much more. Whether you are a buyer or seller, this show will be invaluable to understand the mechanics of SBA 7 (a) loans.

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. Even better, 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 financing has allowed us to finance million-dollar transactions with as little as $20,000 cash down.

Qualifications

While numerous qualifications exist, retirement plans should be fully accessible and should be enabled to be rolled over into another plan.

Penalties

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

Advantages

• Seller receives cash at closing, which can increase the buyer’s negotiating leverage
• Business pays off the debt using operating income
• Interest on the debt is tax-deductible
• High success rate of obtaining funding, which increases negotiating leverage

Disadvantages

• Longer time frame
• May require an annual appraisal
• May require ongoing maintenance fees

Common Transaction Structures

Common transaction structures are listed below and are broken down into three broad categories: all cash, seller financing, and bank (SBA) financing. A 401(k) rollover is included as cash and counts as the buyer’s personal equity.

• All Cash
  • 100% cash
• Seller Financing
  • 50% cash down payment, 50% seller financing
• Bank or SBA Financing
  • 20% cash down payment, 80% SBA financing
• Hybrid
  • 10% cash down payment, 10% seller note, 80% SBA financing

We 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 (e.g., tax benefits, etc.)

A 401 (k) rollover can also be used in combination with seller or bank financing.

Other Forms of Financing

The forms of financing mentioned above comprise approximately 95% of all forms of financing used for the acquisition of small businesses. Other forms of financing exist, but they have not been proven to be readily available and accessible.