Some entrepreneurs and small business owners get into business by starting their own companies. Others buy companies to get into business. When you take the second route, you’re (hopefully) buying a successful, stable operation that won’t collapse if or when its founders or current executives leave. But a successful, stable operation rarely comes cheap.
Buying something that already works can set you back by hundreds of thousands, or even millions, of dollars. Very few people have the liquid capital available to buy an established business outright, which is why even successful entrepreneurs will often turn to a particular financing mechanism to complete a business buyout: business acquisition loans.
Let’s look at the typical structure and form of a business acquisition loan, the requirements you’ll need to meet in order to obtain these loans, and the best business loan options for several common entrepreneurial scenarios.
Types of business acquisition loans
There’s no single type of financing for a business acquisition loan. This term is really just a professional way to say “a loan to buy a business,” and there can be several types of small business loans that fit the bill:
- SBA loans
- Seller financing
- Rollover for business startups
- Alternative lenders
What is an SBA loan?
One popular source for a loan to buy a business is the Small Business Administration (SBA). An SBA loan is typically available only to the most qualified borrowers, which means you’ll need nearly flawless personal and business credit to get one.
The benefit to pursuing an SBA loan as business acquisition financing is you’ll typically get the best possible rates and repayment terms. The downside to an SBA loan is the wait time — some SBA loans take more than a year to process — and the low likelihood of approval.
You’ll usually get an SBA loan through a traditional bank, but the backing of the U.S. Small Business Administration can make it somewhat easier to obtain than a fully bank-funded loan. By guaranteeing a large part of the loan the SBA allows a bank to accept a higher level of lending risk, which means you simply need nearly flawless credit, rather than the absolutely spotless credit a bank might require when funding you on its own.
Most of these loans are offered as SBA 7(a) loans. You’ll also occasionally see a CDC/504 loan from the SBA. However, the CDC/504 loan is a fixed-asset loan (a business can be considered a fixed asset) that’s harder to obtain and requires more paperwork. When time is of the essence in buying a business and getting to work, SBA loans’ extensive documentation demands and high hurdles to approval can be too much to overcome their occasional cost benefits.
Most SBA 7(a) loans to buy a business max out at $5 million. They can have terms of anywhere from 10 to 25 years, but larger loan amounts, such as those for loans to buy businesses, will usually have loan terms on the higher end of the scale at 20 to 25 years. The interest rates on SBA loans are pegged to the prime rate, which is the benchmark interest rate set by the U.S. Federal Reserve, and will usually be offered at a few points above the prime rate. There’s also a “guarantee fee” of 3% or more, charged by the SBA to guarantee the loan and generally passed down to you through the bank loan.
What you’ll need to get an SBA loan
You’ll probably be asked for a business plan, even if you’re buying a business that’s operated successfully and profitably for many years. You may be able to work with your seller to quickly develop a working plan, but to maximize your chances of success, you’ll want to produce something polished.
As an added benefit, you’ll learn a lot about that business’ ins and outs while writing a business plan, and you may even discover the opportunity isn’t quite as good as you first thought. If you feel your entrepreneurial sense tingling in the wrong way while writing a business plan, don’t feel bad about stepping away. There are always more opportunities to buy businesses.
In addition to a business plan, you’ll need a signed letter of intent and/or a purchase agreement, which are legal documents confirming the proposed acquisition and its proposed price. A letter of intent isn’t a binding contract for a business acquisition, but it can get the loan process in motion while you agree to final terms and craft a detailed purchase agreement with the seller. Few banks will approve an SBA loan to buy a business without a purchase agreement.
You’ll also need a personal credit score of 650 or better just to be considered, and you’ll have a much better chance of approval if your credit score is 680 or better.
You’ll need to provide a number of documents to apply for an SBA loan, including several years of both personal tax returns and business tax returns, as well as financial statements such as the business’ income statement and balance sheet.
Banks also want to see documentation of all outstanding debts and receivables the business holds, and documentation for all its durable or current assets as well. The business’ paper trail will need to be clear and clean to get a bank’s stamp of approval on an SBA loan. Poor cash flow, a lack of profitability, and a lack of growth in the business’ history can all make lenders wary of funding your acquisition, as it can be much harder to succeed with a business that isn’t already demonstrably successful.
An SBA loan requires a down payment of at least 10% of the purchase price. Some bank loans will require as much as 25% down for approval. You can fund part (up to half) of your down payment with seller financing, which we’ll discuss shortly, but you’ll have to pay at least half of the down payment from your own capital. The seller must generally agree to subordinate their financing to the SBA loan as well, which means they agree not to enforce your repayment until after you’ve paid off the SBA loan.
What is alternative lending?
Alternative lenders are often available to step into the gaps left by low SBA loan approval rates and difficult restrictions on other forms of financing. Alternative lenders can structure multiple different forms of financing to help you achieve your goal of buying a business. Depending on the type of business you’re trying to buy, you may be eligible for:
Some business acquisition financing from alternative lenders can include multiple forms of funding. If you have good personal and business credit history, and the business you’re buying has an established record of profitability, an alternative lender might extend: a term loan for the bulk of your acquisition; a business line of credit to support post-acquisition growth; and equipment financing to cover any heavy machinery either owned or urgently needed by the acquired business.
Many entrepreneurs looking for a loan to buy a business work with alternative lenders due to the flexibility of financing options and their higher approval rates. Funding extended by alternative lenders can also be paired with seller financing to cover much of the purchase price.
One major advantage of alternative lending over SBA loans is the relatively few restrictions on the use of your funds. The forms of funding listed here are (except for equipment financing) generally usable for any valid business purpose. If you feel like you’ll need extra capital to run a marketing campaign, hire new staff, or renovate the business’ storefront, you can request it in your loan application, and you’ll generally be able to use any financing left over from the business purchase to tackle critical business projects right away.
Some alternative lenders (like those we work with) can make up to $20 million available to qualified buyers. More traditional forms of funding offered by alternative lenders, like term loans, will be structured with three- to five-year repayment schedules at interest rates not much different than those of SBA loans. Other forms of funding, like business lines of credit, have repayment requirements similar to those of credit cards. If you’d like to learn more about your financing options with alternative lenders, check the links in the list above.
What you’ll need to get financing from alternative lenders
The personal credit threshold tends to be much lower with alternative lenders than with SBA loans, as some buyers can be approved with personal credit scores as low as 450. However, larger transactions with more moving parts — such as a term loan to buy a business — may require a personal credit score of 650 or greater.
Alternative lenders will want to do their due diligence, just the same as banks, but documentation requirements can be less stringent, and processing times much shorter, than they might be for similarly-sized SBA loans. A skilled alternative lending broker can help you figure out your best options and put together a package of financing that works for you.
You may not need a business plan to secure financing from an alternative lender. However, you’re likely to need ample documentation on both your personal and the business’ financial histories, to demonstrate the viability of your proposed purchase and your ability to operate it once the deal closes. Talk to your funding specialist to determine what forms and other paperwork you’ll need.
You can also pick up a free guide to non-bank financing that will walk you through the common funding mechanisms offered by alternative lenders, and what purposes they best serve, right from this page. Just scroll to the end of the post and click “Download Now” to access the guide.
What is seller financing?
If the business owner believes in your commitment and trusts your judgement (and your credit record), they may offer you seller financing. When you obtain seller financing, the business owner is essentially agreeing to transfer ownership for less than the full sale price. The difference between the cash a seller receives and the sale value of their business is covered by a promissory note (a form of debt contract) in which you promise to pay them back the difference over a set time frame.
Seller financing is rarely the sole form of financing you’ll use, as most owners want to get a good chunk of the sale price in cash. As a result, you’ll probably see offers for seller financing in the range of 15% to 60% of the sale price, if the business owner is willing to finance the transaction in the first place. Keep in mind that you’ll be restricted in the amount of seller financing you can take if you’re funding a large part of your business acquisition with an SBA loan.
What you’ll need to get seller financing
There’s no single answer to “what will I need to get seller financing?” because this form of funding comes directly from the entity selling you the business. Each seller will have their own requirements and restrictions. You’ll probably negotiate those terms directly if seller financing is placed on the table during acquisition discussions.
Most sellers will expect you to have a credit score of at least 600, although some may agree to finance your purchase if you have a lower score. You’ll probably need to provide some kind of business plan as well, to demonstrate your understanding of the business and your ability to keep it operating profitably after the sale.
Diligent sellers will probably check (almost) as many financial factors as a bank, but they’ll be more motivated to speed the process along to get their payout. Sellers that provide financing for you to buy their business will also typically be more motivated to provide you with accurate and detailed business financial statements. That can come in handy when seeking other forms of funding to fill in the gaps typically left by seller financing.
What is a rollover for business startups (ROBS)?
Finally, a rollover for business startups (ROBS) is not a traditional loan in the sense that you’ll take on debt that has to be paid back. Rather, a ROBS is a way to convert funds held in an eligible retirement account into capital for investing into a business. Contrary to the name, you can use a ROBS to buy an existing business as well as to start a new business.
A ROBS will often make capital available to you faster than an SBA loan. However, your fees can be high, the documentation requirements can be steep, and you can run into real legal or tax trouble if the ROBS is administered incorrectly.
What you’ll need to get a ROBS
You typically need to hold at least $50,000 in an eligible retirement account, such as a 401(k), IRA, or 403(b). It’s not absolutely necessary to have this amount in your accounts, but at this stage we’re accounting for the setup fees professional ROBS providers often charge to help you get proper access to your retirement capital.
You can try to save money by doing it yourself, but there are a number of legally complex steps involved in setting up and lawfully administering a ROBS to invest in an existing business. The cost and stress involved in potential non-compliance are likely to outweigh the benefits of doing it yourself by a huge margin.
A ROBS is likely to be the most complex and legally demanding of all your options for financing a business acquisition. Consider the costs — setup fees typically run around $5,000, and there are ongoing monthly payments for maintenance fees that will typically run $100 to $150 per month — and the legal restrictions on ROBS investments as well as the advantages of faster access to your capital.
Other alternatives for funding a business acquisition
Some entrepreneurs have other sources of funding for buying a business. Two popular alternatives to the four listed here are the home equity line of credit (HELOC) or home equity loan (HEL), and financing provided by friends and family.
Home equity financing
HELOCs are similar to other lines of credit, except they’re secured by your home. You’ll only be able to borrow against a HELOC in the amount of any available equity you’ve built up in your home. If your mortgage is fully paid, you’ll be able to access more credit than if you’ve only been making payments for five years. You can borrow any amount, up to the limit of the HELOC, and will pay interest only on what you’ve borrowed. This can be a good option if you don’t need a massive amount of financing, or if you expect to have major expenses involved in getting the business running on your terms after you’ve bought it.
A HEL is a one-time loan, similar to a term loan or SBA loan. You’ll get a lump sum up front and will need to pay it back every month. The only difference between using a HEL to buy a business and simply taking out a HEL to fund any other major life expense is your use of the funds. Anyone who’s taken out a second loan or mortgage on their home should be familiar with the way HELs work.
You’ll need to own at least 20% of your home’s equity to get a HELOC or HEL, which will be easier for those with longer homeownership histories. In the early years of paying your mortgage, most of your payments will go towards the mortgage interest rather than the principle, which leaves you with little equity until you’ve pushed through that big wall of upfront interest. Most traditional banks tend to require you to have a personal credit score of 620 or greater to take out a HELOC or HEL to fund a business acquisition.
Friends and family financing
Friends-and-family financing (or F&F financing) is an alternative for those who know people of means with a willingness to invest in a major asset purchase.
This can be easier to obtain than other forms of financing, but there’s rarely such a thing as problem-free F&F loan. You’ll need to appropriately document the loan(s) and treat them seriously if you want to maintain your reputation with friends and family. Few things can destroy relationships quite so completely as major money issues.
Make sure you’ve got a signed loan agreement and a way to separate F&F financing from any of your personal funds, to ensure you’re only putting the money towards its stated purpose. If you don’t have a business bank account, you should establish one for F&F financing, both to separate it from any personal funds and to have an easy way to document your use of the proceeds, should your friends or family ask for more insight into your business purchase.
Know your options
In most cases, a HELOC, HEL, or F&F financing won’t be enough to cover your business acquisition, so you’ll need to incorporate other forms of funding to complete the deal.
But when properly combined, these forms of financing can help you buy a business with relatively little liquid cash on hand. There’s no one-size-fits-all solution, so make sure you talk to a professional to understand your options and develop a strategy that works for your business acquisition.
After reading all this, do you feel confident in your ability to finance the purchase of a business? If you’ve still got questions, we can help! Just reach out at any time (try our interactive chat feature, which you’ll see as a little button on the bottom left of your screen) to get started.