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Financing A Business Purchase

There are many ways to structure the sale of a business that makes sense for both buyer and seller. Creative financing is an area where Sunbelt of Nashville can help. We can recommend a variety of payment options that are available which, in many cases, can mean the difference between a successful transaction and one that is not. Developing a solid understanding of how business purchases are funded is essential for both business buyers and sellers. We encourage all business buyers and sellers to familiarize themselves with the most common forms of financing used for business transactions. The following paragraphs can help you get started with your research, however be sure to speak with your Sunbelt business intermediary to obtain more details about the current market conditions.

Bank Financing

Bank financing for small business is typically in the form of SBA loans. Loans are approved and originated by SBA participating lenders. The SBA, in turn, agrees to guarantee some percentage of the principal balance of the load (usually 50%-70%). SBA-backed loans are subject to specific underwriting guidelines regarding fees, interest rates, collateral, personal guarantees, amortization, covenants, and other forms of debt. The primary SBA business loans used by business buyers to buy a business are the 7A program and the 504 program. A 504 SBA loan is used to buy real estate and long-life equipment. It normally requires a 15% down payment and the term of the SBA loan is 20 years. A 7A SBA loan is used to purchase other business assets, such as inventory, working capital, equipment, and goodwill (the excess of the purchase price over the value of the underlying assets). This SBA loan normally requires a 20% down payment and the term of the SBA loan is up to 10 years. SBA 504 loans will have a fixed interest rate while the 7A program will have a variable interest rate.

To learn more about the SBA and its loan programs, go to www.sba.gov or talk to your Sunbelt of Nashville Broker. In specific circumstances, non-SBA bank loans may also be available, but it is less common.

The following paragraphs summarize a number of basic concepts and terms with which we recommend you become familiar. Your Sunbelt business intermediary, accountant, attorney and banker will be able to work with you to identify and evaluate your best bank financing options. Larger transactions typically include one or more of the following forms of bank financing.

  • Asset Backed Lenders/Loans vs Cash Flow Lenders/Loans – An asset backed loan is any kind of loan that is secured by an asset, usually a tangible asset such as inventory, accounts receivable, machinery and equipment, etc. Cash flow loans are loans which are made against the future cash flow of the borrower. Cash flow borrowers are typically companies with minimal tangible assets; examples of these types of borrowers would be software companies, professional service businesses (such as law firms and medical practices), etc. If you are evaluating acquisition opportunities and plan to use bank financing, it is important to make an early determination as to whether you will be obtaining an asset backed loan or a cash flow loan. Most banks are asset backed lenders rather than cash flow lenders and, consequently, cash flow loans are typically more difficult to obtain.
  •  Senior and Subordinated Loans – Senior debt takes priority over other forms of debt in the event the borrower goes bankrupt or needs to be liquidated. Senior debt typically has a first lien or claim on specific assets. Subordinated debt, which is sometimes referred to as mezzanine financing, may also have a lien or claim on the borrowers’ assets, but the lien or claim would be subordinated to the claims of the senior debt holder’s claims. Because subordinated debt is less secure than senior debt, it carries a higher interest rate. Typically, the interest rate is an additional 3% to 6% for subordinated debt versus senior debt; however, the spread or difference can be higher or lower depending on the borrower’s circumstances. Despite the higher interest rate, many Middle Market business buyers use subordinated debt rather than diluting their equity ownership by bringing in equity partners.
  • Interest Rates and Bank Fees – Interest rates on Middle Market bank loans are typically expressed as a function of either LIBOR or Prime Rate. LIBOR is an acronym for the London Inter Bank Offered Rate. The Prime Rate is the interest rate charged by US banks to their most creditworthy customers. Historically, LIBOR is lower than the Prime Rate, but the amount of the spread varies based upon credit market conditions. There are various reasons why a Middle Market borrower may want a LIBOR or Prime Rate based borrowing rate and you should discuss the relevant factors and options with your banker; that said, it is most likely that you will have a Prime Rate based loan. Whether you have a LIBOR or Prime Rate based loan, your interest rate will likely be variable and your repayment period will likely be less than five years. For example, your interest rate may be Prime, plus 100 basis points (bps – remember that 100 basis point equals 1%, so if Prime were 4% and your interest rate was Prime plus 100 basis points, your effective borrowing rate would be 5%). In addition to the interest payments on the loan balance, banks often charge fees to their borrowers. There is usually a loan origination fee, which includes the bank’s legal fees for preparing the loan documents and other costs. Depending upon the nature of the loan, bank fees can be significant, so you should make sure these are negotiated at the early stages of your discussions with the bank.
  • Covenants – The legal documents used to document a bank loan typically include debt covenants. It is very important to carefully understand and negotiate your debt covenants as the bank will require you to comply with these covenants throughout the term of the loan. Failure to comply with the loan’s covenants may either (a) affect the interest rate being paid on the loan, or (b) give the bank the right to terminate the loan. While there are a myriad of loan covenants, common examples include: (a) the need to provide the bank with annual, audited financial statements and unaudited interim financial statements, (b) the maintenance of specified financial ratios during the term of the loan (common financial ratios that are considered include net working capital, EBIDA to debt service, tangible net worth to total debt, etc), (c) restrictions on the disbursements of funds to the owners of the business/borrower and (d) key man life insurance for the business owner. There are many, many other common covenants; don’t be surprised to see 20 to 30 debt covenants in a loan.

These are the most common ways that a buyer can finance the purchase of a business. Sunbelt of Nashville is very familiar with SBA loans and will help buyers find a lender.

Seller Financing

A portion of the financing for a typical transaction commonly comes from the business seller. We refer to this form of financing as seller held notes or seller paper. The amount and terms of seller financing agreements vary significantly depending on the nature of the business being sold, the general availability of third party financing, the buyers cash down payment and various other factors. The willingness of a seller to provide some financing is also an important psychological factor for some buyers in that it can be interpreted by buyers as a demonstration of the seller's confidence in the future prospects of the business being sold. While the interest rate on seller held notes varies, we usually see rates of 6% to 10%, depending upon prevailing interest rates, and the expected repayment period.

In the larger business transactions, sellers may provide some form of non contingent financing, but it is less common. That said, larger transactions often include an earn-out provision which effectively makes a portion of the business sales/purchase price contingent upon on the future performance of the business. Earn-out provisions are popular with buyers in that they help mitigate the business buyer's downside risk. They are especially common when there is a significant fluctuation in the business' historical financial performance and/or historical to projected financial performance. Your Sunbelt business intermediary and accountants can assist you in determining what if any earn-out components should be included in the purchase price/offer for a business.

Retirement Fund Financing

IRA and 401KAlthough not obvious to many, even knowledgeable observers, pension, profit sharing, 401(k), 403(b), other retirement plan and rollover IRA money may be used to fund your investment. This can be done without distributions, taxes, penalties, or the use of loans. It’s sort of a self-venture-capitalization. These transactions are within the clear letter of the law.  There is a very specific process to be followed when using these funding mechanisms, so it is important to use a firm that specializes in this type of transaction. Sunbelt of Nashville has formed a strategic alliance with two companies that have developed a way to move money locked in 401(k) or other IRA rollover accounts directly into a new or established business without distributions, taxes, penalties or the use of loans. The money may be used for franchises, property, equipment or working capital.

If you have funds that are locked in a retirement fund, we can access those funds to help you realize your dream of buying a business through our relationship with this company. Please ask your broker for more information on this process.

Other Forms of Financing

  • Home Equity Loan - This is a quick way to finance the down payment or purchase price. It also is usually the lowest interest rate for the buyer.
  • Credit Cards - There are many businesses that got started, or financed, on a credit card.
  • Friends and Family - If these people are going to finance the purchase, we do require that they verify this directly with us.

Again, we encourage your to work with you Sunbelt of Nashville Broker to assist you in identifying and evaluating the best financing options for your business purchase.