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How to Finance a Business Purchase

Jeff Baxter Jr.

Buying a Business Buyer Articles Buyer FAQ

Buying a business is an exciting endeavor. You’re probably eager to get started - but one question always comes up quickly: how will you pay the purchase price? 

Fortunately, financing a business acquisition has never been easier. There are a handful of ways to finance your small business acquisition. 

At MidStreet, we’ve helped hundreds of buyers use financing to purchase a business. We’ve seen many different structures work and know the drawbacks and benefits of each. 

To give you an idea of the various ways you could finance a business, we’ll cover the most common ways including: seller financing, SBA 7(a) loans, capital from family and investors, or your personal funds.     

Let’s hop in. 

4 Ways You Can Finance a Business Purchase

For the context of this blog, we will be referring to how individual buyers can receive financing. Strategic buyers and private equity groups usually have more access to capital to purchase a business. 

There are a few financing options available to individual buyers looking to purchase a business:

  • Seller financing
  • SBA 7(a) loan 
  • Money from family or investors 
  • Personal funds 

When individuals are researching how to afford a business purchase, they should also consider all aspects of the price. They should think about obtaining funds to cover: 

  • The down payment - A percentage of the overall project cost of the deal. This will usually be around 10-15%. 
  • The loan payments - The monthly payments you will make to pay off the loan. 
  • Working capital - How much money you need to operate after purchasing. 
  • Post-closing liquidity - Funds to cover your personal bills and unexpected circumstances after closing. 

By thinking of each of these ahead, you can be better prepared for all of the costs associated with purchasing and operating a business. 

1. See If The Owner Will Offer You Seller Financing 

Seller financing comes in two primary structures. The seller can either finance a portion or all of the sale price to you. 

If they offer seller financing for the whole amount, you will pay them in a similar way you would pay off a bank loan. If they only seller finance a portion of the sale, it can come in two forms: 

  • A traditional seller note 
  • As a part of the equity injection

In the case of a traditional seller note, you will owe the seller the full amount of the note plus interest in around 3 - 6 years. For a seller note used in the equity injection, the seller can be repaid after the SBA loan, which typically has a 10-year term. 

To help you visualize a partial seller financing scenario, imagine you are buying ABC HVAC Company. The purchase price is $2 million which equates to a roughly $300,000 down payment using typical SBA loan terms. What if you have $225,000 to put down but not $300,000?

If the seller agreed to provide you with a seller note of $500,000 this would decrease the down payment to around $225,000, assuming the other terms of the deal stay the same.

To test out your own seller financing scenario and understand how the payments would work, download our free seller financing calculator below. 

 

Pros of seller financing: 

  • Can serve as an alternative to the SBA process 
  • Makes business sales possible for buyers and businesses that do not qualify for SBA 
  • Helps young or inexperienced, but capable buyers purchase businesses 
  • Quicker than the SBA 7(a) loan process

Cons of seller financing: 

  • Buyers need a bigger down payment (around 25-50% of the project cost)
  • Can be difficult to get the seller to agree to finance a majority of the purchase price 
  • Buyers will not have the SBA to thoroughly review the business 
  • Buyers need to get a separate working capital loan (usually included in an SBA 7(a) loan)

2. Apply For an SBA 7(a) Loan 

An SBA 7(a) loan is one of the primary ways individual buyers receive financing to purchase a business. An SBA 7(a) loan is a government-guaranteed loan program that establishes a set of criteria that individual lenders follow. 

It is hard to receive a loan directly from a bank without the SBA. The SBA removes the uncertainty for the bank, providing them with protection in the case that you default on the loan. 

The SBA 7(a) loan program is designed to help individuals receive a loan of up to $5 million to purchase a business. This makes it a great financing option for buyers purchasing lower middle-market businesses. 

However, the SBA has specific requirements for buyers looking to apply. The SBA will not approve loans for businesses in some industries but most will qualify.

To picture an SBA scenario, say you receive the following terms from an SBA lender on the HVAC business you plan to purchase for $1,750,000: 

  • Purchase Price of $1,750,000
  • Working capital loan of $100,000
  • Estimated SBA fees and closing costs of $66,500
  • Down payment of $287,500
  • Loan request of $1,629,000
  • Loan term of 120 months and a 6% interest rate
  • Monthly payments of $18,085

At closing, you will be responsible for the down payment of $287,500. The SBA fees and working capital are part of your loan. You will gradually pay off the $66,500 with the rest of the loan amount and receive the $100,000 to cover your operating expenses as you get started. 

Fortunately, the business you are purchasing has usually earned $500,000 in SDE each year or $41,600 on average, making the monthly loan payments of $18,085 per month manageable. 

Much like purchasing a house, your SBA loan will have a down payment you are expected to bring to the closing table. You are responsible for bringing $287,500 to closing in this example, but what are your options for coming up with this money?

There are a couple of options for coming up with the down payment for your SBA 7a loan:

1. The most common way is to pay the down payment out of money you have saved without investors. In that case, you would bring the whole $287,500 to closing yourself.

2. You can find investors that want to play an active role in the business and come in above 20% ownership. For instance, you invest with a partner and split the business 50/50. This is often a great strategy because you can mix skill sets and keep the workload manageable. In this case, you would be responsible for bringing $143,750 to closing and so would your business partner.

3. Another alternative strategy is finding passive investors who provide capital but do not work in the day-to-day operations of the company. In our example scenario, you might find an investor who brings $200,000 and receives 15% ownership.

This 15% ownership could receive 15% of the profit (or more) after the SBA is paid and the managing partner takes a salary (say, $60,000). This means the business made a profit of $500,000 then the active partner was paid $60,000 and the SBA was paid $217,020 leaving $222,980.

The passive investor would receive $33,447 on his investment of $200,000 which is a 16.7% return. Another benefit of this set up is the passive investor has less than 20% ownership and therefore is not required to personally guarantee the SBA loan. 

Pros of SBA financing: 

  • It will help you fund the purchase if you don’t have more than 20% down or other investors
  • The SBA can help fund the working capital amount you need 
  • They do high goodwill transactions that most conventional lenders will not do

Cons of SBA financing: 

  • The SBA has a lot of requirements and can take a while
  • There are limitations to the type of businesses you can buy with it 
  • There are additional SBA fees associated with an SBA loan 
  • Not all businesses can be purchased / approved through the SBA

3. Raise Money From Others or With Others (No SBA Loan)

There are many ways you can raise money to buy a business, but these are the main ways: 

1. Your family or friends loan you money - This is usually pretty straightforward. It can be given as a gift, in exchange for equity in the business, or given to you as a loan. 

2. An outside person gives you a loan (debt financing) - In this case, you replace an SBA loan with a private loan. The individual most likely gives you a loan with an interest rate between 5-8% to compensate for the risk they are taking on.

3. An outside person purchases the business with you (equity partner) - In this instance, you will have a partnership where your combined capital allows you to buy the business. 

Pros of raising money from others to purchase a business: 

  • Can serve as an alternative to the SBA process if you or the business does not qualify
  • Many investors have excess cash to invest in small business deals

Cons of raising funds from others to buy a business: 

  • It can be time-consuming and hard to find an investor if you don’t have a network
  • Investors offering you a loan will generally charge higher interest rates than the SBA 
  • Investors receiving an equity stake in the company receive a disproportionate amount of the profit 

4. Pay All Cash With Your Personal Funds

Paying all cash to purchase a business is one of the most direct methods. You just need to be sure you have enough funds to purchase the business outright while still having enough to cover your living expenses and the operating costs of the business. 

As we mentioned above, you should be thinking about the following costs, especially if you are paying straight cash for the business: 

  • The down payment 
  • The working capital 
  • Your personal expenses and other investments

Take for example the HVAC company we discussed earlier. You would need the purchase price ($1,750,000), working capital ($100,000), and some additional funds for your own bills. 

The total would be about $1,850,000 plus closing costs. Depending on the accounts receivable process of the HVAC company, the working capital you need will vary. In this case, having $100,000 on hand sounds like a lot but might be too little if customers are slow to pay.

In the case that you are paying straight cash for the business, you should give yourself a nice cushion with business and life expenses. You do not want to spend $1,850,000 for the business if $1,850,000 is all the money you feel comfortable investing in the business. 

Pros of paying all cash for the business: 

  • You get to receive all the profit and don’t have to pay interest 
  • You don’t have to answer to anyone else or provide financial information to others
  • You can close very quickly and this will be attractive to some sellers
  • You can buy any type of business you want

Cons of paying all cash for the business:

  • Less available funds for an emergency or other situation 
  • Limits what size of business you can afford
  • You won’t have the experience and support of a second investor

Know How You Can Finance Your Business Acquisition 

Ultimately, you will decide how you finance a business purchase. Now that you know the four ways you can fund it, you can better assess which method works best for you. 

As an individual buyer, the SBA 7(a) loan can be one of the easiest ways to afford a business. Learn more about the SBA process by reading “How to Buy a Business Using the SBA 7(a) Loan Program (With Example).” 

If you are considering purchasing a business, knowing exactly how much you will need can be difficult. Give us a call today to learn more about the costs. 

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