Business acquisitions may be financed in a variety of ways. Buyer’s either pay all cash, becoming their own financier, seek Seller Financing or Third Party Financing through an SBA Loan, Conventional Commercial Loan, Home Equity Loan, Private Party Loan, Venture Capital, etc. There are other sources who lend against assets or accounts receivable, (known as factoring) for specialized situations once you own the business.
Let’s take a quick look at a few of these scenarios.
In a cash transaction the Buyer has no debt after the acquisition. This takes a lot of pressure of the new business owner. They may have structured the sale from an accounting standpoint to have loaned their Corporation the money, so the Corporation has to repay the individual the loan, but they are repaying themselves in a sense. This is a nice option. As long as you have left yourself appropriate working capital to run the business you can immediately start repaying yourself with the profits of the business, having no debt service or interest due to an outside source.
With seller financing the Seller typically has a first position lien on all the assets and inventory of the business. It show a lot of confidence in the business and the Buyer for the Seller to do this and generally these types of transactions require a substantial down payment, usually 1/2 or more of the overall purchase price. If the Buyer defaults the Seller with take back the business. Many Sellers are unwilling to do this as they do not how the Buyer will perform and they may be relocating or just not want to be in the position to have to take the business back. If the Seller will hold even a small amount of paper in a transaction, it is likely they will answer the phone when a Buyer has a question post closing. This is a big potential benefit. However the Seller usually likes to have a first position lien or some realistic collateral to do this. They don’t want to be in a secondary position with no collateral.
SBA financing can generally be done with between 20-25% down of the overall project cost. Project cost refers to the price of the business, loan closing costs, working capital etc. It is possible to put say $100,000 down on a $500,000 transaction and get $20,000 or more back at the closing table for working capital. Lack of working capital is one of the biggest reasons small businesses fail. They put every dime into the acquisition and may have immediate cash flow problems because of lack of cash flow from businesses that carry large accounts receivable or perhaps may be seasonal for example. Having working capital that at least matches the receivables is a minimum rule of thumb. (assuming your not buying the receivables in an asset sale) The Buyer may not start receiving A/R for 45 to 60 days after the acquisition, but meanwhile will be incurring payroll, cost of goods, operating expenses, etc.
SBA Loans put a first position lien on all the assets and inventory of the business, current and replacements. They also look for additional personal collateral, a second on your house, or a lien on other personal assets. Business assets can be here today and gone tomorrow and Lenders don’t give much credibility to the assets really securing their loan. Some Lenders won’t even do SBA loans unless the businesses real estate is involved. Then, in a worst case scenario, they have something to go after. These loans require excellent credit on behalf of the Buyer / Borrower and well documented cash flow on behalf of the Business / Seller.
It typically takes about $25,000 of cash flow or owner benefit to service every $100k of debt as a rule of thumb. Lenders look for a 1.2 or 1.25 debt service coverage ratio. This means the businesses cash flow must cover the debt service and the Borrowers salary requirements 100% and then have a 20-25% safety margin of unutilized cash flow. Generally speaking, your 20-25% equity into an SBA loan is not supposed to be borrowed money, this hampers your debt service coverage ratio and the Lender must account for repayment of that loan as well, however many Buyers do take home equity loans out first and use the money as their equity into an SBA loan.
Conventional commercial loans from the commercial loan division of your favorite local bank are tough to get on a small business unless you can collaterize the loan with personal assets. These loans are generally much easier and faster, but are typically based on your personal net worth, banking relationships and willingness to pledge personal assets.