Buying a business is a risky endeavor - you have to place your faith and your money in a company you believe in but don’t know everything about.
Wanting to know the costs associated with this risk is natural and exactly what you should be thinking about.
If you have a realistic idea of the amount you will need as a down payment to buy a business, you can accurately direct your search and plan ahead.
At MidStreet, we regularly vet buyers who inquire about our available business listings. We assess if potential buyers have the necessary funds to buy and operate the business and inform them of what type of down payment they will need to provide.
To help you prepare for this important investment, this article will cover how much of a down payment is usually required to buy a business and what can increase or decrease the down payment.
Let’s jump in.
What is an Average Down Payment to Purchase a Business?
Down payments are usually 10-15% of the total project cost, but rates can vary by lender. The total project cost will include all costs associated with the business sale.
Most small businesses are acquired using a loan through the Small Business Administration (SBA) 7(a) loan program, which was designed by the government to make it possible for more individuals to get approved for small business loans.
We will use SBA requirements as a basis for our examples to help you better understand how much you will need as a down payment to purchase a business.
The SBA requires a 10% down payment minimum when using the SBA 7(a) loan program to buy a business. However, most 7(a) loans fall between 10% and 15% required down payment.
To err on the side of caution, you should calculate the amount you will need for a down payment assuming it will be a 15% rate. If you can get a loan with a lower rate, you can adjust accordingly later on.
How to Calculate an SBA Loan Down Payment
To form an accurate idea of the down payment you will need to purchase a business using an SBA 7(a) loan, you can use the following equation:
Project Cost * 15% = Down Payment
To get the project cost, you will use this formula:
Purchase Price + Real Estate (if purchasing) + Working Capital Loan (if necessary) + SBA Fees + Closing Costs = Project Cost
Here is an example of what this down payment equation would look like, starting with calculating the project cost:
$2,000,000 (business price) + $500,000 (real estate price) + $200,000 (working capital) + ~$100,000 (SBA fees) + ~10,000 (closing costs) = $2,810,000 (project cost)
If you multiply the project cost of $2,810,000 by 15%, you will find that you need around $421,500 as a down payment. If you can get a low down payment rate through the SBA, the minimum down payment will be around $281,000 (at 10% down).
What Affects the Down Payment Required to Buy a Business?
There are a variety of factors that impact the down payment the SBA will approve on a loan, including:
- The buyer’s experience in the industry
- The strength of the business
- The business industry and its revenue pattern
To qualify for a 10% down payment, industry experience in the type of business you are purchasing is typically required. Additionally, to get a 10% down payment everything must go well during the deal - there will be little room to account for changes in deal terms.
When Would You Pay Less Than 10% Down on a Business Purchase?
There are two ways you can pay less than 10% down on a business while still technically providing 10% down - you can ask for seller carry or find a minority investor.
1. Seller Carry
Seller carry is when the owner selling you the business is willing to loan you a portion of the down payment and receive it back as a seller note once the life of the loan is complete.
This would be considered part of the equity injection and means that the seller is loaning you (the buyer) this portion of the down payment for 10 years minimum. The maximum the seller can contribute to the down payment is 5%, which would leave the other 5% as the buyer’s responsibility.
NOTESBA standard operating procedures state "Seller debt may not be considered as part of the equity injection unless it is on full standby for the life of the SBA loan and it does not exceed half of the required equity injection." This rule binds the seller to agree that if they contribute to the buyer's down payment, they will not have access to that money until the end of the loan.
2. Minority Investor
With the SBA 7(a) loan program, a minority investor can bring a large portion of the down payment. As long as the minority investor is a silent partner, they can bring a larger share of the down payment while not giving a personal loan guarantee. This is common and a great way to purchase a business with less than 10% down yourself.
When Would You Pay More Than 15% Down on a Business?
The debt service coverage ratio (DSCR) can affect the size of the down payment you will need to buy a business. The debt service coverage ratio represents the ratio between the business’s profit and the loan payments. For instance, if the loan payments are $100 and the profit is $200 then the DSCR is 2.00.
If the debt service coverage ratio is close to or at 1.25, lenders may request you bring a larger down payment to reduce the loan payments.
If the DSCR is 1.25, that shows that the company’s profit is only slightly higher than the loan payments, making the business riskier to lenders.
Plan Ahead For the Down Payment You Will Need to Pay
Now that you know how much of a down payment you will usually need to buy a business and what influences it, you can better prepare.
If you know a minority investor willing to help you fund the down payment, you may be able to expand your buying options. You may also encounter a seller who is willing to contribute to the down payment with a seller note.
A good business broker will set a realistic expectation of whether they think the business opportunity will be a fit for you financially by assessing your funds in comparison to the down payment, working capital, and other fees required to purchase the business.
To find out more about how long it takes to buy a business, check out our blog “How Long Does it Take to Buy a Business?”
If you are interested in buying a business and want to learn more about what type of down payment you will need, feel free to give us a call today.