How To Finance a Buying a Business

The wave of corporate downsizing in the US has made business ownership look more appealing than ever. As more prospective buyers try to become independent owners, one question keeps coming up: how to finance buying a business?

Prospective buyers know the credit crunch makes a traditional bank an unlikely answer. So where can buyers turn for help with what may be the biggest investment of their lives? There are many ways to finance a business acquisition, and buyers can find one that fits their needs. Small businesses priced under $100,000 to $150,000 usually depend on seller financing as their main source. For many firms, these are the best routes to follow:

Buyer’s Personal Equity

In most business acquisition deals, this is the place to start. Usually, 20 to 50 percent of the cash needed comes from the buyer and family. Buyers should decide how much they can risk, and the amount will depend on the business and the deal terms. On average, a buyer should be ready to bring $50,000 to $150,000 for a small business purchase.

A highly leveraged deal, with very little cash, must stay a dream for most buyers. The exceptions are buyers with rare skills that investors want, businesses that create jobs of local public interest, or firms that are expected to make very large profits.

One major reason personal equity is a good start is that buyers who invest their own money get the deal moving. Their commitment can encourage other investors or lenders to join in.

Seller Financing for Buying a Business

One of the simplest and best ways to finance the purchase of a business is to work closely with the seller. The seller’s willingness to help will depend on tax issues and cash needs.

Sometimes sellers must finance the sale to keep the deal alive. In other cases, they prefer to do the financing themselves. That can raise the odds of a sale and help the seller get a better price.

Seller terms are usually more flexible and buyer-friendly than third-party terms. Sellers will typically finance 50 to 60 percent or more of the price, with an interest rate below current bank rates and a far longer loan term. Payments are often set up much like those in conventional loans.

Like buyer equity, seller financing can make the business more attractive to other lenders. In fact, outside lenders often like the steady payment plan that comes with seller financing.

Venture Capital

Venture capitalists have become more willing to fund large independent businesses. They once focused on high-risk, brand-new companies, but now they also look at established firms.

That does not mean outside equity investors are waiting at the buyer’s door, especially if the buyer expects one investor to carry the whole risk. Professional venture capitalists worry less about risk, but they often want majority control and may expect at least a 30 percent annual rate of return on their investment.

SBA Loans for Business Acquisition

The US Small Business Administration Loan Guarantee Program gives buyers better financing terms. Like seller financing, SBA loans have long repayment periods, often ten years, and up to 70 percent financing. That is more than buyers usually get with a seller-financed sale.

SBA loans are not automatic, however. The buyer must show that the business is stable and must also offer collateral, such as machinery, equipment, or real estate. There must also be proof of healthy cash flow so loan payments can be made. If cash flow is strong but collateral is weak, the buyer may need to offer personal collateral, such as a house or other property.

Over the years, the SBA has become more in tune with small business financing. It now has a program for loans under $150,000 that requires only a minimum of paperwork and information. Another good sign is that more banks and lending institutions are being approved as SBA lenders.

Bank Loans to Buy a Business

Banks and other lenders may offer unsecured loans to buy a business based on the cash flow available to cover the debt. The term unsecured is misleading, because banks and other lenders of this type still try to secure the loan if collateral exists.

Buyers have more success when they have a large net worth, liquid assets, or a reliable source of income. Unsecured loans are also easier to get if the buyer is already a favored customer or qualifies for the SBA loan program.

When a bank helps finance a business sale, it will typically fund 50 to 75 percent of real estate value, 75 to 90 percent of new equipment value, or 50 percent of inventory. The only intangible assets that banks tend to like are accounts receivable, which they will finance at 80 to 90 percent.

Although the terms may sound attractive, most buyers are wise not to depend on conventional banks for business acquisition financing. By some estimates, the rejection rate for bank loans for a business acquisition can be more than 80 percent.

With any financing option, buyers need creative solutions and a willingness to take some risks. Whether they choose personal funds, seller financing, or third-party financing, a well-informed buyer can feel confident that a solution exists. Business acquisition financing exists in many forms.

Q&A

Question: What financing source should a buyer generally consider first when acquiring a business?

Short answer: Start with the buyer’s personal equity. Buyers often provide 20 to 50 percent of the cash needed, sometimes with help from family. This shows commitment and can help persuade sellers, lenders, or investors to join the deal.

Question: Why is seller financing often an attractive option for small business acquisitions?

Short answer: Seller financing is often flexible, practical, and easier to arrange than third-party financing. Sellers may finance 50 to 60 percent or more of the selling price, often at rates below current bank rates and with a longer loan term. For small businesses priced under $100,000 to $150,000, it is usually the main source of financing.

Question: Are SBA loans automatically available to business buyers?

Short answer: No. SBA loans can offer good terms, including long repayment periods and up to 70 percent financing, but the buyer still must qualify. The buyer must show that the business is stable, prove healthy cash flow, and provide collateral, which may include business assets or personal assets such as a house or other property.

Question: Why might venture capital not be suitable for every business buyer?

Short answer: Venture capital may work for some larger or stronger businesses, but investors usually want major control and a high return. Professional venture capitalists may want majority control and may expect at least a 30 percent annual rate of return, which can make this option a poor fit for buyers who want control.

Question: Why does the article caution buyers against relying too heavily on conventional bank financing?

Short answer: Conventional bank financing can be hard to get for business acquisitions. Banks favor borrowers with strong net worth, liquid assets, and reliable income. They also look closely at collateral. The article says bank rejection rates for business acquisition loans can be above 80 percent, so buyers should compare several options.

Working with a reputable business broker is a valuable resource when buying or selling a business, and VR Business Brokers of Raleigh is happy to give you as many resources as you need to make your buying or selling process as seamless as possible. Here are some more articles from our experts.

Written by Occam