For the last several years there is no question that financing has been the most difficult hurdle in buying a business. With the collapse of the financial markets in late 2007 and the onset of the Great Recession, traditional sources of funding pretty much dried up.
But as I update this article, the situation is much improved. Consumer and business confidence are up and banks are lending money again. That being said, however, we’re still not quite where we were back before the recession in the availability of loans for business acquisitions.
So let’s review the current available options for financing. There are five places to find money for the purchase of a business. We’ll discuss each below.
Many times the older generation in a family will loan the down payment or the entire amount needed to a promising member of the family’s younger generation. If your family is willing to loan you the money, one word of advice is in order. Have a very clear understanding as to how the debt is to be handled and put it in writing in the form of a legal note.
And even though it is family, I also suggest that the note carry a market rate of interest. The written note with a reasonable rate of interest will not attract the attention of the IRS who otherwise might try to reclassify the loan as a taxable gift or income. Also, a legal note that earns interest might help keep peace in the family, particularly among other family members who might be a tad jealous.
Although most people seeking a loan to buy a business will think first of banks, I can tell you from years of business brokerage experience that banks generally do not make business acquisition loans.
That statement will surprise most people. Once you’re in business, banks will compete for your patronage, but most will not stick their necks out in the beginning to make you a business acquisition loan. Bank advertising would lead you to believe they would do so, but in more than 90% of the cases, they will find some reason to decline the business acquisition loan application. This is particularly true in today’s economy.
The exception might be if you have a strong, years-long relationship with a bank and you can offer some other collateral such as Certificates of Deposits. Or if the bank participates in the SBA loan program, they might be able to approve a SBA guaranteed loan (see SBA below).
So if a bank turns you down, don’t take it personally. And don’t take it as a reflection on the business. It’s just the way things are.
Now this is the humorous part of the situation. It’s ironic but it has happened more than just a few times. After you’ve been in business for a number of months or a year or so, the same bank that turned you down for a loan to buy the business may come calling on you soliciting your banking business! One of my clients in this situation said to the banker in an air of seriousness, “Well now Mr. Banker, we’ll be happy to consider your application for our business. Let’s see, we’ll need your financial statement and a list of references and your business plan for five years into the future. Once we have your completed application, I’ll be glad to take it before my committee and let you know of our decision.”
The banker was taken aback. I thought it was funny.
The SBA, through its approved lenders, provides business acquisition loans. The SBA generally does not make direct loans, but rather guarantees a portion of the loan that is made by the approved lender. It’s known as the SBA 7(a) program.
The SBA list of approved lenders includes many banks. If you go the SBA route, try to use a SBA designated “Preferred Lender.” The preferred lenders have more local authority and can sometimes cut through the bureaucracy. Some of these lenders will include an amount for working capital in addition to the price of the business in the loan amount. Down payment requirements range from 20% to 25% plus there are usually up-front fees involved for various requirements. Interest rates are competitive with the marketplace.
The SBA guaranteed loan requires a lot of detail and documentation. If you go this route, be patient. And stay on top of the SBA requests for information. The quicker you can get the information and documentation to the SBA underwriter, the quicker your loan will close.
The SBA route for a business acquisition loan is sometimes frustrating because of the time and detail that is involved. However, keep in mind that the SBA will approve loans that others have turned down and will usually approve them with a smaller down payment. In most cases, it’s worth the wait.
In the majority of the business transfers that I have handled, particularly over the last three years, the owner of the business has financed a portion of the purchase price for the buyer. Some sellers cannot offer owner financing for a variety of reasons, but when they can, it conveniently solves the problem of financing.
The fact that the business owner is willing to finance the sale of his company provides more than a convenient finance plan. More importantly, it provides a strong validation of the owner’s belief that the business will support the owner and earn enough cash to pay back the loan. You can’t get any better recommendation on the business than this.
Owner financing also keeps the owner “in the boat” for the duration of the loan. If the new owner experiences any problems, the seller has a vested interest in assisting.
The normal down payment for owner financing ranges generally from around 25 to 50 percent of the purchase price of the business. Interest rates are generally market driven but there is more flexibility here than in other forms of financing.
Of course, the owner is going to want to know a little about you before making a commitment to finance. If you’re going to ask him to finance the business for you, be prepared when you meet him to give him some background information on yourself and your business or work experience. Remember, you need to sell him on your qualifications as much as you need to be sold on his business. In future meetings with him, assuming you are seriously interested in buying the business, it would be an act of good faith on your part to give him your personal financial statement, a list of references and a copy of your credit bureau report (if it’s good). That shows professionalism.
Most owner financing – though not all — is in the form of a balloon note. The balloon note solves two opposing desires. The buyer of the business wants to keep his payments low; however, the seller usually wants his money as soon as possible. By amortizing the note (calculating the payments) on, say, a 12-year payback schedule, the payments are kept low. But the inclusion of a 5-year balloon requires that the balance be paid off at the end of five years. After the new owner has been in business for five years and has built a track record for himself at this bank, he should have no trouble going to the bank and refinancing the balloon. In the low interest rate environment of recent years, I’ve seen new owners refinancing the balloon even before it came due to save money. The balloon note has been a win-win vehicle for both buyers and sellers.
401(K) FUNDS AND IRA ACCOUNTS
The use of 401(k) and IRA funds to buy a business, without tax penalty, is a fairly recent development. Several national CPA and attorney groups have developed a plan, approved by the IRS, which allows you to use your funds for business acquisition.
There are legal and accounting fees involved in setting up the arrangement, but the fees are a small fraction of the tax penalty that would be assessed for cashing in these accounts. For additional information on this option, call your CPA, attorney or business broker.
In my business brokerage practice, we have developed a relationship with a couple of firms that specialize in this area and we can make a referral for you.
The above five sources of financing are not exclusive to each other. I recently handled a transaction in which three of the five sources were used to buy the business.
It’s called creativity!
# # #William Bruce is a business broker and appraiser. He currently serves as president of the American Business Brokers Association. He may be reached by phone at (251) 990-5934 or by email at Will@WilliamBruce.org. If you found this content helpful, share it using the links below.