Looking for your next business venture, but don’t want to think of a new idea? Consider purchasing an existing business instead! But whether you’re already a business owner planning to add a new business to your portfolio or a first-time entrepreneur who’s never owned a business before, there are a few things you’ll need to know before following through with a business acquisition.
While buying an existing business could prove less risky than starting from scratch, business acquisitions often involve high upfront costs. If you don’t have the cash on hand to make that big business purchase, though, don’t despair—try a business acquisition loan instead.
The Challenge of Borrowing for Business Acquisition
First, you should know upfront: business acquisition loans are famously difficult to nab. That’s because every business acquisition loan has so many factors in play—the borrower’s financial history, the history of the business getting acquired, the viability of the prospective new owner’s plans for the business, and the borrower’s qualifications for making the existing business succeed.
Plus, because so many aspects of a business’s value—like name recognition and industry goodwill—are intangible, and might not transfer with a change in ownership, lenders can have a hard time accepting a purchase price based on these factors.
That said, while obtaining a business acquisition loan to purchase an existing business is difficult, it’s not impossible. If you’re qualified, organized, and do the legwork to make your case to your lender, you have a chance of securing the debt financing you need for that business acquisition.
Let’s explore the different types of business acquisition loans available, the qualities that make up a fundable business acquisition, and the materials you’ll need to submit a successful business acquisition loan application. We’ll also look at a few alternative funding options worth considering for your business acquisition.
Types of Business Acquisition Loans
While there’s no single specific loan type designed for business acquisitions, there are certainly a few small business loan products that simply fit better for the business acquisitions process. Here are the main loan types you’ll probably want to consider as you seek funding for your business acquisition.
If you’re looking for a business acquisition loan with a fixed interest rate and predictable monthly payments, a traditional term loan will fit you well. It’s the easiest to understand, because it’s probably what you naturally think of when you think of a business loan.
The terms are pretty simple—you borrow a fixed amount of money, usually for a specifically stated business purpose—and pay back the loan over a fixed term and typically at a fixed interest rate.
Term loans are the most common loan type for business acquisition, since they fit in well with the typical cost and the long-term nature of purchasing an existing business. However, many lenders will have high standards for your business acquisition deal in order to fund your term loan, and you might not qualify on your first try—so prepare for one or several lengthy applications to secure a term loan for your business acquisition.
SBA 7(a) Loan
Because of the widely accepted difficulty of obtaining a traditional term loan from a bank or alternative lender for business acquisition, many small business loan brokers recommend that borrowers pursue business acquisition loans through the U.S. Small Business Administration.
Contrary to what the commonly-used term “SBA Loan” suggests, the SBA actually doesn’t directly lend money to small businesses. Instead, the agency works with a number of lenders around the country to guarantee all or part of those loans, incentivizing lenders to approve more loans for smaller businesses.
Typically, the size and relative risk of lending money to small businesses make lenders hesitant to approve these loans. The SBA aims to increase the chances that small businesses will get approved for funding by mitigating some of the risk for the lenders.
This is great news for borrowers hoping to acquire existing businesses, since the SBA would lessen the risk of the deal and make it more likely that lenders will approve business acquisition loans.
Out of the SBA’s various programs, the 7(a) loan program is both the most common and the most appropriate for the business acquisitions process. This program allows small business owners to borrow up to $5 million in funds for working capital, equipment purchases, real estate purchases, and even basic startup costs.
Qualification for SBA 7(a) loans is left to the discretion of intermediary lenders—but it often depends on your time in business, annual revenue, and personal credit score. However, the backing of the SBA does usually make lenders more likely to approve term loans through this program that they’d otherwise reject.
If you’re a relatively new entrepreneur looking to buy an existing business on your own, you’ll probably want to look at a startup loan. These are typically still term loans, but they’re available through specific lenders who won’t expect revenue or credit history from an existing business when they evaluate your finances as the borrower.
While startup loans for business acquisition do exist, they’re difficult to come by and involve intense scrutiny into your personal finances. Additionally, the lender will expect you to put some skin in the game, usually in the form of at least 20% of the purchase price as a down payment.
In some cases, if the majority of the purchase price for the business you’re acquiring is based on the value of equipment being transferred, an equipment loan could be a great source of financing for your business acquisition. A small business equipment loan can be used for virtually any equipment need—from computers to production machinery, to vehicles, and more.
As a point of reference, compare equipment financing to a standard car loan: the amount you can borrow depends on the type of equipment, the price, and whether it’s new or used. The lender also considers the expected life of the equipment and its current condition.
Of course, any funds obtained through an equipment loan can only be used toward the cost of equipment. So any difference between the value of the equipment and the total acquisition cost of the business need to be funded in a different manner, either through personal savings, an equity investor, or a second supplementary loan.
Considering Your Finances as the Buyer
Once you’ve determined which type of loan fits your business acquisition best, you’ll need to prepare your personal finances, as well as those of any businesses you already own for review by your lender.
Just like with any small business loan, lenders will carefully scrutinize both your personal financial history and the history of your business to determine whether you’re a strong candidate for a business loan. Let’s quickly review the main criteria lenders consider when they assess your personal and business finances.
Personal Credit Score
When you apply for a business loan, you might be surprised to learn that your personal credit score is one of the most important factors in determining your loan eligibility! Especially if you’re looking for a startup loan, lenders see your credit score as a significant factor in your likelihood of making your business acquisition work in order to make your loan repayments.
From the lender’s point of view, they’re lending money to a small business owner, not just the business itself. So as the business owner, how you handle your personal finances is incredibly significant.
If your credit score is 700 or above—Congratulations! You’re in great shape, and will likely have excellent small business lending options available.
Is your credit score between 650-699? Great! You should still have plenty of options.
If your credit score is 575-649 range, that’s considered average. You probably won’t qualify for the very best interest rates out there, but depending on other financial considerations, you’ll likely still have some options available.
Unfortunately, if your credit score is in the mid-500 range or lower, you have what’s considered a poor credit rating and will have few if any options available.
Business Credit Score
If you already own a business, your personal credit score is only the beginning of the evaluation lenders will make into your finances as the borrower. They’ll also review your business credit score and history as one of many important factors in determining your eligibility for a business acquisition loan.
Your business credit score is determined through five main factors: your payment history, amounts owed, your length of credit history, types of credit used, and your new credit. Again, payment history is the most significant of these factors, so it’s critical to always make debt payments on time, both personally and for your business.
Dun & Bradstreet and FICO Small Business are the leading resources to monitor your business credit rating, so check your reports regularly with each agency to avoid inaccurate reporting.
Your lender might ask to verify your personal income as well as the revenue of your existing business through your state and federal tax returns. Have your last two to three years of tax returns available when submitting your application—and if you haven’t yet filed tax returns for the current fiscal year, provide your extension paperwork to make it clear that you’re still in good standing with the IRS.
Cash Flow Statement
The cash flow of your existing business acts as a snapshot of its financial health and an indication of whether your existing business can support the debt and the uncertainty of a business acquisition. Positive cash flow is a sign that you’re managing your business finances well, and a strong profit margin gives you the necessary buffer to make payments on your acquisition alone, even if your newly acquired business isn’t immediately profitable.
Almost all lenders agree that an acquisition is not a realistic way to “save” a business facing cash flow issues or operating at a loss, so don’t expect to be approved for a business acquisition loan if your current business is struggling financially.
If your current business has any outstanding debts indicated on your balance sheet or other financial records, this can have a serious impact on your ability to qualify for a business acquisition loan. Typically, your current outstanding debts will take “first position,” meaning that in the event that your business could not repay all its debts, they would be the first ones to get repaid.
Most lenders don’t like to approve loans in which they won’t be in first position, and this is especially true for business acquisition loans. Because of the relatively risky nature of acquisitions, it’s in your best interest to settle any outstanding debts in order to have any hope of being approved for a new loan.
Evaluating the Business to Be Acquired
In a traditional business loan situation, the lender’s evaluation would start and end with your personal and business finances. After all, what other financials are there? But this is the big reason that business acquisition loans are so difficult to come by: the lender will also be evaluating the financial history of the business you’re hoping to acquire.
For many borrowers, this is the most stressful part of the process, since you have very little control over the financial standing of a business you don’t yet own. But if you take a different perspective, your lender is in many ways doing the due diligence for you. If your lender identifies some flaw in the financials of the business you’re looking to buy, they could save you a lot of stress from unknowingly acquiring a business in financial trouble.
Let’s review the main pieces of the financial puzzle lenders will scrutinize within the business you are hoping to acquire. You’ll likely need to work with the seller or current business owner in order to provide this documentation.
Lenders will review the balance sheet for the business to be acquired to determine the value of tangible, fixed assets that will be transferred in ownership at the time of the business sale, as well as identify any liabilities or outstanding debts the business holds.
Evaluating the business’s assets helps lenders verify the purchase price, and allows them to identify goods that might be liquidated in the event of a loan default or business failure.
In some cases, if the new business has a significant number of fixed assets, they might be used as collateral for your business acquisition loan. This is good news for you as the borrower and buyer, as it reduces the likelihood that you’ll be asked to offer your own personal collateral or sign a personal guarantee for the loan amount.
As with your existing business, lenders will want to see the last two or three years of federal and state tax returns for the business to be acquired in order to verify revenue history.
As they review the balance sheet, income statement, tax returns, and other financial documentation for the business you’re hoping to acquire, the lender’s primary objective will be to identify the business’s current profit margin. If the business is not currently profitable, or has many outstanding debts, it will likely be seen as a risky acquisition and therefore not fundable.
Pay attention to the profitability and cash flow of the business you are looking to acquire. These elements are strong indicators of whether the business is succeeding or failing—and you certainly don’t want to jump on a sinking ship!
Does the Deal Make Sense?
In every aspect of their thorough review process, your lender is ultimately trying to determine whether the business acquisition deal makes sense. Is there an obvious reason why you’re a good fit to own this business? Do you have the talent, contacts, and resources needed to make the business succeed? Does the valuation of the business give you a reasonable opportunity to turn a profit?
Outside of the dollars and cents, here are some other important criteria lenders assess when they review your business acquisition loan application.
To determine a fair price for your business acquisition (and therefore a smart amount for your loan), your lender might ask for a formal business valuation performed by an independent valuation firm. Through this process, the consultant will look at both tangible and intangible aspects of the business to determine a monetary value under various scenarios.
When analyzing a business, valuation consultants typically account for all expected profits in the foreseeable future, then discount the future profit projected for each year by the rate of return they expect. However, there are several outside factors that could impact the valuation of your business. For example, how essential are the current business owner’s expertise or industry contacts to the business’s success? Considerations like these could impact how valuable the business would be after an acquisition.
Your Related Experience
In addition to setting an approximate cost, the lender will consider how your work experience as a business owner will contribute to the future of the business post-acquisition. Are you experienced in the industry of your desired business? Will you have the tools you need to make your business succeed? Do you have any specific skills, expertise, or contacts that make the business likely to succeed more because of your involvement?
Conversely, if you have relatively little experience in the industry of your desired business, that could be seen as a red flag to the lender. After all, if you don’t have the skill needed to run the business, that initial valuation likely won’t last long.
If you’re looking to purchase an existing business, you’d do so with a plan to change operations, pursue a different strategy, or take some measure to improve the existing business’s profitability. The strategy you take will have a significant impact on the long-term viability of the business, and so on your ability to repay your business acquisition loan.
Along with your loan application, you want to submit a detailed business plan for your new business explaining the history of your business is current strategy, plans you might have to make changes or add value in the future, and a plan for transitioning to your new strategy.
To wrap up your business plan, you’ll want to go back to the numbers and provide some thoroughly researched data-based sales projections for the next two years. These projections should be based on the business’s historical sales records, while also taking into account your strategy for moving forward.
While it’s okay to be confident here, know that your projections won’t be taken at face value, and will need to be backed up with verifiable data. And even with the data on your side, lenders will downgrade your projections by about 10% as standard practice.
As they review your personal experience, business plan, and future projections, along with the business valuation, lenders are really looking to answer one question: What value do you add to the business that will make it better and more successful than before you acquired it?
That might be a new strategy, a piece of equipment, a customer base, or any number of tangible or intangible contributions.
If you can provide a strong, provable answer to that question, there’s a good chance that lenders will see your business acquisition as a good, fundable deal.
While the process of proving to a lender your business acquisition is a good deal might feel tedious, consider that ultimately the lender is also at risk in a bad deal. If you’re unable to be approved for a business acquisition loan, that might be a sign from these experienced financial professionals that it might be worth reconsidering the viability of your business acquisition.
And if you are approved for your acquisition loan, congratulations! Not only do you have a way to fund your business acquisition, but you also have a strong vote of confidence in the viability of your purchase plan.
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from Fundera Ledger https://www.fundera.com/blog/2015/12/23/business-acquisition-loans/