Business Purchase Financing
Business purchase financing is one of the major hurdles that both the buyer and seller need to address early in the process. Many deals are not completed because the funding could not be secured. In the current lending environment, banks are more stringent than ever, so both buyers and sellers should be aware of what is needed to successfully secure a lending partner.
An overview of Business Purchase Financing
SBA 7a loans are often used for business acquisitions for transactions that range from $250,000 to $2,000,000. Banks underwrite the loans and the SBA guarantees them. Many buyers think that because the SBA / federal government is guaranteeing the loan that it will sail through. This is simply not the case. Banks will lose money if the buyer defaults, and the SBA has rigid guidelines that the banks must follow. More information on this topic later.
It is difficult to secure business purchase financing for deals below $250,000 and above $2,000,000. For deals below $250,000 buyers usually use home equity, savings, grants, seller financing or a combination thereof to purchase a business. For deals that are above $2,000,000, small M & A deals, the financing structure varies and is beyond the scope of this article. Banks usually will not finance a business unless that business has a documented history of profitability.
A View of Business Purchase Financing from the Bank's Point of View
What exactly is the bank financing? Unlike real estate, the bank is primarily financing goodwill which is intangible. The bank is financing an ongoing concern, a income generating operation, that is switching from one owner to another. The transition represents risk to the bank. A business may have been successful under one owner, but that owner is leaving! The new owner could run the business into the ground. Since the bulk of the sales price is goodwill, not hard assets, the bank would be left with very little to recoup any losses. Enter the SBA. Without the SBA these loans would not exist. With this being said here are the concerns of the banks - Cash flow, fixed assets, credit and history of the buyer and collateral. The SBA has criteria for these areas and each bank also has their own ratios for each of these items and some are more aggressive than others. (Remember, the banks do their own underwriting) Banks look at both the financial history of the buyer and the business to make their decisions.
Important factors buyers should know about business purchase financing before beginning their search
1. Down payment. Business purchase financing almost always requires 10% - 30% cash equity from the buyer. A seller's note may be counted as a part of the down payment but the buyer will still need at least 10% - 15% cash to invest. The buyer can use home equity, pensions, IRAs etc. for down payments.
2. Credit. Buyers need to have excellent credit. Any negative credit history at all will be a problem. A very detailed personal financial history form must be completed and approved by the SBA. If you are married the SBA will also look at the credit of your spouse. If your credit is less than above average you may be able to get approved with non-spouse, co-signer.
3. Experience of the Buyer. For business purchase financing to be secured banks and the SBA will look at the experience of the buyer to gauge the degree of risk involved. If a business is highly technical or require significant expertise then the buyer will probably need that on their resume. For less complicated businesses, any sort of business leadership experience is very helpful. Buyers would be smart to have a resume prepared that documents past business operation experience. (Any, however insignificant, is better than none)
4. Interest rate. The rates are negotiable and it is advisable to shop the market. SBA loans are limited to 2.25% above the prime rate in the Wall Street Journal for loans with maturities of less than 7 years, and limited 2.75% with maturities of 7 years or more. As of this writing, Feb 2008, the WSJ prime rate is down to 6% from 7.25% only a month ago and 8.25% a year ago. Great news if you want to purchase a business. (6+2.25= 8.25%)
5. Term of Loan. Varies by bank. Many banks advertise up to 25 years for SBA loans. This is usually for a SBA loan that involves Real Estate. Straight business purchase financing is usually 7-15 years.
6. The discretionary earnings for the business should cover the debt and provide the buyer with a reasonable income. (Another reason that your personal financial history is required) Banks are realistic, you need to pay your bills. Alternative sources of income helps - spousal, investment, rental, etc.
To read more about discretionary earnings and how it relates to business purchase financing click here.
7. Seller involvement. If the seller is involved with the business post sale and has a stake in the outcome that reduces the risk to the bank. Small seller's notes are often needed and the seller may be required to continue to work in the business for an extended period of time.
**UPDATE 2009: With the current financial crisis seller financing is virtually required on all SBA loans. Sellers should plan to carry a note of a percentage of the transaction. Please call for more details.**
More on Seller Financing here
8. Will you have to put up your home? Debt for business purchase financing often times, must be secured with real estate. (Home or otherwise) Yet this may depend on the bank and the overall strength of the deal. For example, if a buyer comes in with a sizable down payment then he or she may not have to use property as collateral. But if the buyer is highly leveraged then he or she will probably need to secure part of the debt with real estate.
9. Personnel. It is very important that the staff, employees & management, stay in place. Banks may require agreements that note who is staying. This is not usually a problem since people usually want to keep their job.
10. Working capital. Some businesses require a large amount of working capital. Banks will look at what kinds of terms the business is on with it's customers and the size of accounts receivable to determine how much working capital a buyer will need. Some banks will finance some or all of the working capital but this will increase the total loan amount.
The bottom line on Business Purchase Financing?
As of June 2009, financing is extremely difficult to secure. For a bank to finance a transaction the seller and buyer have to work together to "package" the deal in the most favorable light. This often requires a fair amount of legwork but it is worth it for both parties if it makes the deal work.
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