5 Ways to Finance the Purchase of a Business
By Tim Dalton
Probably the biggest obstacle to selling a small business is for the purchaser to obtain financing. Larger, strategic buyers or private equity groups tend to have the financial capabilities or their own funds to make a purchase, but the challenge is that these purchasers are typically looking for business opportunities with minimum sales of $10 million and a bottom line of more than $1 million. Most small businesses don’t meet this criteria, and a buyer is left with finding a means to finance the purchase.
There are several ways to finance a business purchase.
Conventional bank financing: Although this is where most business buyers start their financing search, it is probably one of the more difficult ways to obtain financing for a purchase. Banks are small business advocates and help many of their clients, but when it comes to an acquisition with an individual they don’t have a prior small business relationship with, it can understandably become more difficult.
A lender looks for collateral to cover the loan should there be a default, and, unfortunately, if a small business closes its doors, there is not much value left in the non-operating business. There might be some used equipment and maybe some inventory, but in most cases, not nearly enough to cover the outstanding loan amount. For this reason, a conventional bank loan might be challenging.
Small Business Administration (SBA) financing: The government is in a position to help with business acquisition financing through its 7(a) and 504 loan programs. With these loan programs, the government is typically not the lender, but it is a guarantor of a portion of the acquisition loan a bank might provide. Here’s an example: A purchaser comes with a 20 percent down payment and the SBA provides a 50 percent guarantee; now the bank only has a 30 percent liability should there be a default. Like I said, banks are not crazy about acquisition loans, but if they have the government helping to guarantee a portion of the loan, they do become more receptive.
Retirement funds: There are several companies that specialize in a buyer using their retirement funds to invest in a business purchase without triggering penalties and taxes.
With a 401(k) plan, your money can be invested in stocks of a corporation as part of your investment strategy. What these companies have put into place is that now a business purchaser can use his or her 401(k) money to invest in (purchase) a corporation using those funds without penalty.
This method of financing a purchase is well vetted and comes with IRS approval.
Family and friends: This is where a lot of business purchasers turn for financing. Who better to believe in a purchaser’s dream and abilities than the people who know him or her best?
Seller Financing: Prior to conventional bank financing or SBA financing, seller financing was the main source of funds for a business purchase, and it is still a good means today. Most sellers would like to get 100 percent cash for their business at closing, and that is understandable.
However, many business owners do a poor job with their financial recordkeeping, which will turn off many banks. This gives the opinion to a purchaser that if a bank is not willing to finance, it must be a bad business.
Many times, this is not the case, and there is no better way for a business seller to give confidence to a buyer about the quality and viability of a business than to say he or she is willing to back it up with seller financing. There is no such thing as a guarantee of future success, but if the seller is financing the purchase, that is about as close as you will come.