Of the many considerations when purchasing a small business, one of the most important is how to finance it. Even if you have all of the cash you need to buy a business, as a smart investor you will consider whether you are better off borrowing some of the money or bringing in an equity partner to spread the risk.
Each source of business acquisition financing has its benefits and drawbacks. Before you identify a business that meets your acquisition criteria you should understand how large a business you can afford and where you can secure the funds. You can mix and match the financing strategies below depending on your needs and qualifications, and the deal’s size and complexity:
• Family and friends. If you don’t have the initial capital to acquire a business, consider asking friends and family for help. Those who are close to you and believe in you may be willing to take a chance on your business. The investment could be a gift, a loan or an equity investment in the business. Each have pluses and minuses, and each should be recorded in writing, in many cases a legal document. While a gift may be the most straight forward way for your friends and family to support you, many experts suggest loans as the optimal way for personal relationships to invest in your business plans because there are clear expectations and repayment terms. If you accept an equity investment you are literally turning a friend or family-member into a business partner. This type of relationship can be fraught with challenges and misunderstandings so be sure to clearly define the terms of the investment.
• Seller financing. Consider asking the seller of the business if he or she can provide financing for the sale of all or some of it. The benefit to the seller is that they may make more on a loan to you than alternative investments available to them. Also by taking a note rather than cash they may be able to defer some of the taxes on the sale of the business. There are benefits for the buyer too. In some cases, sellers may provide more reasonable interest rate than the banks. Also sellers that retain a note still have an interest in the success of what was once their business. This can provide you with a built-in source for advice and guidance.
• Bank Loan. To obtain a loan from a bank to purchase a business both the target business and the buyer must be able to qualify. The business should have positive cash flow, solid management experience, industry expertise and a strong credit report. You, as the buyer, must have good credit (at least 640 FICO score), business management experience and in some cases personal collateral to back the loan. Many lenders across the country offer small-business loans guaranteed by the U.S. Small Business Administration (SBA) 7a program. These loans provide lenient and flexible financing for qualifying borrowers. SBA loans have low down payment requirements (as low as 10% on some deals), are structured without balloon payments and have up to 10 year terms which keep loan payments low.
One substantial downside to the SBA loans is that they require personal guarantees, putting you personally on the hook for any defaults by the company. Typical bank loans don’t always have this requirement for businesses generating enough cash flow. SBA 7a loans can have higher interest rates than traditional bank loans. They also require more paperwork and a greater time investment in the documentation and approval process.
• 401k/IRA. An often overlooked source of acquisition funding is your personal 401k or IRA. The benefit of this approach is that there is no penalty for early withdrawal nor requirements to repay the funds back into your retirement vehicle. The Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (ERISA) include provisions that permit individuals to invest their retirement funds in stock in their own companies. Often called ROBS (Rollover for Business Start-Ups) the process is fairly straightforward but there are a few legal hurdles, so consult a professional. Also be prudent with your investment as you’ll be risking your retirement savings in your business.
It is important to have a financing strategy prior to making an offer to purchase a business. Contact Adam Wiskind, M&A Broker with Exit Strategies Group, Inc. to discuss your financing options. He can be reached at (707) 781 8744 or firstname.lastname@example.org.