When purchasing a business there are several options for buyers to finance the purchase. In this blog post, we will dive into the various types of financing available and give both buyers and sellers insights on the options.
It’s important for sellers to understand the financing options for buyers because the easier it is for a buyer to finance the purchase of their business, the larger the pool of buyers, which generally means better price and terms for the seller.
Small Business Administration (SBA) Loans:
SBA loans are loans provided by banks and lenders in partnership with the U.S. Small Business Administration. The most popular is the SBA 7(a) loan. These loans limit the risk to the lending bank because 80% of the balance is federally guaranteed. For purchasing a business, the loans are term loans, usually 10 years, with a maximum loan amount of $5 million.
Business owners can also use SBA 7(a) loans to finance working capital needs, refinance debt, real estate acquisitions, or purchasing new equipment. These loans are designed to support small businesses that may not be able to meet the strict requirements of traditional bank loans. SBA loans often have favorable terms, longer repayment periods, and lower down payment requirements.
To get an SBA loan, both the buyer and the business have to qualify. A buyer has to have adequate personal assets to qualify. They typically have to personally guarantee the loan and put 10-15% of the loan balance down as their investment. They can often borrow the purchase price as well as working capital.
The businesses ongoing operations have to be able to support the loan payments. If a business has assets, i.e. equipment, real estate, inventory, or accounts receivable, that also helps the business qualify.
Getting an SBA loan usually takes at least 60-90 days. Banks will usually offer a pre-approval letter saying they believe they can do the loan. Once the deal terms between buyer and seller are set and the loan is pre-approved, the bank will have their underwriters start due diligence. This process involves a thorough review of the businesses financials and the buyer’s personal qualifications. The buyer will be required to submit an extensive application, documents from the business (financials, bank statements, etc.), and a business plan with a budget for future years. Once approved, the bank will fund the loan and the deal can close.
Traditional Bank Loans:
Individual buyers typically prefer SBA loans because they can get better terms, but traditional bank loans are often used by strategic buyers to purchase because they often don’t qualify for an SBA loan. These loans are typically offered by commercial banks and financial institutions, and they involve borrowing a specific amount of money with a fixed repayment schedule and interest rate. Bank loans are suitable for established businesses with a solid credit history and collateral to offer as security.
Private Equity or Family Office Funds:
Private equity (PE) or family offices (FO) are another common source of funding for business acquisitions. PE firms are investment firms that pool capital from various investors, such as institutional investors, high-net-worth individuals, and pension funds, and use that capital to acquire ownership stakes in companies. FOs are similar, except they typically invest the funds from one or more affluent families.
For business acquisitions, private equity and family offices often want the owners or management to stay on for 2-5 years after the purchase. They often only buy a majority share of the business and then give the owners the opportunity for a “second bit at the apple”. This means that, after the 2-5 year period, the original owners can sell the rest of their shares at higher value because the PE or FO has helped grow the business.
Business Lines of Credit, Equipment Financing, and Invoice or Receivables Factoring are additional funding options, but they are rarely used for purchasing a business. They are typically for more specific, operating cash flow needs:
Business Lines of Credit:
A business line of credit is a flexible financing option that provides businesses with access to a predetermined credit limit. Similar to a credit card, businesses can withdraw funds as needed and only pay interest on the amount borrowed. This type of financing for a business purchase is less common because the terms are usually not as attractive as SBA or standard commercial loans, but they are ideal for managing cash flow fluctuations, covering short-term expenses, and seizing immediate business opportunities.
Equipment Financing:
For businesses that require machinery, vehicles, or equipment to operate, equipment financing offers a suitable solution. This type of financing involves obtaining a loan or lease specifically for acquiring the necessary equipment. The equipment itself serves as collateral, making it easier for businesses to secure financing even with limited credit history. Again, these are rarely used to purchase a business, but some investor buyers (i.e. private equity or family offices) will leverage the business’ equipment to obtain funds to help pay for the purchase or grow the business.
Invoice or Accounts Receivable Factoring:
Invoice or receivables factoring allows businesses to convert their outstanding invoices or accounts receivable into immediate cash. With this financing option, businesses sell their invoices or receivables to a factoring company at a discounted rate. The factoring company then assumes the responsibility of collecting payments from the customers. Invoice factoring is particularly beneficial for businesses facing cash flow challenges or dealing with slow-paying clients. Similar to equipment loans, factoring the receivables is sometimes used to help pay for the business or for growth capital post-close.
Sources of Funding for Startups:
Crowdfunding:
In recent years, crowdfunding has emerged as a popular alternative financing method, especially for startups and innovative ventures. Through crowdfunding platforms, entrepreneurs can raise capital by attracting contributions from a large number of individuals. Crowdfunding offers not only financial support but also an opportunity to validate business ideas and build a community of supporters, but it is rarely used to purchase an existing business.
Venture Capital and Angel Investors:
Venture capital and angel investors are individuals or firms that provide funding to startups and high-potential businesses in exchange for equity or ownership stakes. These investors often seek significant returns on their investments and are actively involved in the growth and strategic direction of the businesses they fund. Venture capital and angel investments are suitable for businesses with high growth potential and innovative ideas. If the business has not experienced or does not have perceived potential for high growth, these investors are not likely to invest.
If you need capital for a business acquisition, we encourage you to talk to a bank lender to get pre-qualified. Both the buyer and the business need to qualify to get a loan for an acquisition. If the buyer pre-qualifies it gives them an idea of how much they can afford and also makes bank approval faster once the buyer finds the right business to purchase.
Forging relationships with family offices or private equity groups might also help individual buyers or companies afford larger acquisitions.
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