Bringing buyers and sellers together is only part of the formula toward consummating a transaction. The buyer must be able to procure the necessary funds to finance and close the transaction, and have sufficient working capital to operate the business. Accessing the requisite financing can be a time-consuming and meticulous process. There are often many hoops that buyers (and sellers) must jump through, coupled with the process of articulating the strengths of a fluid business to financiers, who often bring a heavy dose of skepticism to the “underwriting process.”
Touchstone Business Advisors helps buyers to understand how to obtain the necessary financing to buy and operate the business. We maintain close relationships with numerous reliable and experienced financing sources that are equipped to find creative solutions to close deals. We are happy to introduce our clients to the decision makers at these financing institutions to help facilitate timely closings.
Financing an existing business purchase is generally easier than it is for a start up. About 90% of all transactions involve some financing, with only 10% all cash deals. A variety of sources are available to assist you with financing your business purchase.
Banks and Other Lending Institutions
While sufficient cash injection, working capital and a good credit score are prerequisites, many banks also give equal if not more weight to the business’ history of revenue generation. Many of these institutions will also look at your qualifications to run the business based on your skills and business plan. Your credit score will be a factor in determining your credit worthiness. In many instances, the bank will secure the loans through the Small Business Administration’s (SBA’s) 7(a) or one of its affiliated loan programs.
Small Business Loans Backed by the Small Business Administration (SBA)
The SBA does not make the loans directly to consumers, rather through its portfolio of approved lenders, including banks, credit unions and other participating lending institutions. The SBA guarantees loans made by lenders (up to a certain amount) for small business acquisitions.
- The good news is that there is money available; up to $5,000,000 plus, additional funding should it include real estate.
- The terms for repayment are favorable-up to 10 years and greater when real estate is involved
- When a business meets the lender/SBA qualifications, it has passed inspection by a second set of eyes
- If you do not have at least 25% equity in your home, you may not have to fully collateralize the loan.
- Typically, lenders will finance 70-80% of the deal.
You may be thinking, if you can make the acquisition with 20% down, why would you even think about anything else? Here’s why:
- Some small businesses won’t pass the lender/SBA requirements
- You must have transferrable skills or demonstrative experience in a business that is similar to the one you are considering
- The lender may require a life insurance policy and collateralization by your home.
- It can take up to 60+ days to complete the process.
Having said this, it is nevertheless advisable for you to explore the SBA option. You’ll want to approach a “preferred SBA lender”. What this status allows for is the banks to approve the loan on their own without having to submit everything to the SBA in Washington, DC.
The SBA’s loan program guaranties a portion of the loans for existing businesses, a program that helps to minimizes the risk for the lending institution and facilitates the flow of capital to the small business sector. Your best place to start is with one of these lenders. Your loan officer will be able to guide you through the process. An overview of the SBA’s loan programs is available at Quick Guide to SBA Loan Programs.
The vast majority of small business acquisitions involve some amount of seller financing. In fact, it’s estimated that over 80% of transactions include some form of financial aid from the former owner. While the percentages vary, the amount of seller financing is generally 20% to 50% of the total purchase price. When you think about the situation, it makes perfect sense. First of all, by providing financing, the seller validates the viability of the business itself. Also, the seller is able to get the highest price possible by funding part of the acquisition.
A seller may also see tax advantages and profitability in seller financing, but these alone are not usually compelling reasons to offer seller financing. Capital gains from a small business sale can be reported in installments if seller financing is in place. This stretches out the capital gains tax into future years. Interest income on the promissory note may also be more than a seller may receive on other types of investments.
From a buyer’s perspective, seller financing serves to reinforce that the seller is also at risk in the transaction. It’s an insurance mechanism to help ensure that what you’ve been told by the seller is true and accurate. It also serves as a mechanism to deal with situations that may arise later on that come about as a result of their actions where you may need the ability an offset. On the other hand, you will generally have to personally guarantee the loan.
While the terms vary for seller financing, you can expect to pay about 6-8% over three to five years. Plus, you have the ability to get far more creative with seller financing than any other type of financing. You might:
- Negotiate no payments for three-six months after closing
- Allow for the first year to be all principal
- Have the right to make lump sum payments several times a year towards the principal
- No prepayment penalty
- You can arrange for lower payments throughout the loan with a balloon payment down the road
If family members are in a position to help, they are investing in your future and their own. These agreements are sometimes structured so that the lending individual receives a percentage of the annual cash flow or gross income. Others specify a rate and term. Your legal adviser can develop an agreement that allows details the obligations, duties and terms of both parties.
Alternative non-bank lenders have also come into the market place to fill the gap for borrowers whose credit histories make it difficult to secure loans through the traditional lending sector. These lenders recognize that credit scores are not the only indicator of loan repayment. The terms of the loans tend to be shorter and the rates higher. Some alternative lenders cited in a March 5, 2014 New York Times article on alternative lending include Dealstruck, Fundation, and Funding Circle. Having never worked with these alternative lenders, Touchstone Business Advisors is unable to endorse or recommends these companies, and we recommend that you do your due diligence. Discuss with your financial adviser if this is a viable option for you.
Business Loan Checklist
While the requirements vary between lenders, some of the more common items you will be asked to provide include:
- Loan Application
- Reason for applying for the loan
- How the loan proceeds will be used
- Additional assets might you need to purchase
- Biographies of members of your management team
- Resume: Some lenders require evidence of managerial or business experience.
- A Business Plan
- Profit & Loss (P&L) statements, cash flow, balance sheets, and filed tax returns for the last three years. The current owner will provide these documents.
- Credit Report
- Collateral: Collateral requirements vary, but strong business plans and financial statements can lessen this requirement.
- Legal Documents: These documents may include any required licenses, franchise agreements, commercial leases and Articles of Incorporation.