Small Business Acquisition Financing
How do the majority of buyers secure funding for their business acquisitions?
What’s the typical initial cash investment from buyers in a business purchase?
Is seller financing a common practice? And if so, what are the usual terms?
How prevalent are bank loans in business acquisitions?
Are most bank loans categorized as Small Business Administration (SBA) loans?
Can buyers utilize their retirement funds to finance a business purchase?
What are some typical structures for these transactions?
Join us as we demystify the primary avenues through which buyers finance their small business acquisitions. These four primary funding sources include:
- Buyer’s personal equity
- Seller financing
- Bank or Small Business Administration (SBA) financing
- 401(k) rollovers
In the forthcoming article, we’ll delve deeper into each financing source, exploring their respective advantages and disadvantages. Additionally, we’ll shed light on how these various funding methods can be combined to create common transaction structures.
Please note: This article is tailored to businesses valued at $5 million or less. Larger transactions often involve alternative financing sources for acquisitions.
Buyer’s Personal Equity
The buyer’s personal equity plays a pivotal role in small and mid-sized business acquisitions. Typically, buyers contribute anywhere from 10% to 100% of the required capital from their own funds. In the realm of small business acquisitions, most buyers lean towards leveraging their initial investment rather than making an all-cash purchase.
One of the simplest ways to finance the purchase of a small business is through a “seller note.” Seller financing offers more flexibility and often more favorable terms for buyers compared to traditional bank financing.
This option is also faster to arrange and involves less paperwork than dealing with external financing sources, making it particularly appealing when Small Business Administration (SBA) financing is not an option.
How does seller financing work? Let’s say the business is priced at $5,000,000, and the seller offers 50% financing. In this case, the buyer provides $2,500,000 as a down payment and makes payments on the remaining amount until the note is fully paid off. Remarkably, nearly 85% of small business transactions involve some form of seller financing.
Typically, sellers offer financing terms ranging from three to seven years, with interest rates between 5% to 8%.
- Requires less paperwork
- More flexible requirements, including experience and credit
- Lower closing costs
- Faster closing process
- Motivates the seller to ensure the buyer’s success
- Shorter amortization period (typically three to seven years)
- Demands a higher down payment, often at least 50%
- Not all sellers are open to providing seller financing
Bank or SBA Financing
Nearly 95% of bank loans used to acquire small businesses fall under the category of Small Business Administration (SBA) loans. It’s important to clarify that the SBA doesn’t directly lend money to businesses.
Instead, the SBA operates through its 7(a) Loan Program, which assists small businesses in obtaining credit by guaranteeing loans provided by banks in case of borrower default. This guarantee reduces the risk for banks, encouraging them to extend loans to small businesses. As a result, SBA financing often offers buyers more favorable loan terms and interest rates, reducing the necessity for the seller to carry a promissory note.
For buyers, this translates to a lower initial down payment, reduced debt service, and higher net income. Given the government-backed nature of this program, there are well-defined guidelines that banks must adhere to when offering SBA loans. There is usually a nominal fee associated with securing a 7(a) loan, which contributes to sustaining the program.
SBA financing can also be combined with other forms of financing, such as seller financing and 401(k) rollovers.
- Lower initial down payment, typically ranging from 10% to 20% in cash
- Longer amortization period, typically spanning 10 years
- Lower monthly payments due to the extended amortization
- Possible combination with other financing options like seller financing and 401(k) rollovers
- Sellers receive cash at closing, potentially enhancing negotiation leverage
- More extensive paperwork
- Stringent requirements and compliance with specific guidelines
- Typically variable interest rates
- Higher closing costs, usually 3.5% to 4% (regulated by the SBA)
- Longer processing timeframe
- Many SBA loans necessitate a business appraisal
- Lower success rate in obtaining SBA financing compared to seller financing
Buyers also have the option to bypass securing a small business loan entirely by tapping into their retirement funds to fund a new business acquisition. What’s even more advantageous is that purchasing company stock in this manner qualifies as an investment in their own business, sidestepping the need for a taxable distribution. With strategic financing arrangements, we’ve successfully facilitated million-dollar transactions with as little as $20,000 cash upfront.
While various qualifications apply, retirement plans should be readily accessible and amenable to rollovers into another plan.
When executed correctly, there are no penalties associated with using a 401(k) or IRA to finance a business purchase.
- Seller receives cash at closing, bolstering the buyer’s negotiation position
- Business repays the debt using operational income
- Interest on the debt is tax-deductible
- High success rate in securing funding, enhancing negotiation leverage
- Extended time frame
- Potential need for an annual appraisal
- Possible ongoing maintenance fees
Common Transaction Structures
Here are common transaction structures categorized into three main types: all cash, seller financing, and bank (SBA) financing. Additionally, a 401(k) rollover is considered as cash and is part of the buyer’s personal equity.
- 100% cash
- 50% cash down payment, 50% seller financing
Bank or SBA Financing:
- 20% cash down payment, 80% SBA financing
- 10% cash down payment, 10% seller note, 80% SBA financing
We recommend evaluating your financing options in the following order:
- SBA Financing: Start by exploring SBA financing, which typically offers favorable terms such as a low down payment and extended amortization period.
- Seller Financing: Consider seller financing if SBA financing isn’t available or if you have specific reasons for offering seller financing, like tax advantages, for example.
A 401(k) rollover can also be combined with either seller or bank financing as needed.
Other Forms of Financing
The financing options mentioned above make up roughly 95% of all financing methods commonly employed for purchasing small businesses. While other financing methods do exist, their availability and accessibility have not been widely established.