Financing the purchase of a small business – Things you should know

Here is some information from the point of view of a lender regarding the purchase of  a small business.

What does a lender look for in a business acquisition loan?

There are three important factors that a commercial lender looks at when considering a loan to finance the purchase of an existing business:

1)      The cash flow of the business being purchased must be sufficient to repay the proposed loan. In certain cases where the buyer has other income, it might be possible to use a global cash flow. Business underwriting procedures emphasize the most recent year and interim financial statement during the analysis. The traditional cash flow defined as “Net Income plus depreciation, amortization, and interest expense” should provide 1.25 times coverage for the proposed debt repayments. For more information about traditional cash flow please search the site as there are a couple of articles about it. Or you could follow this link: Cash Flow Analysis in that example I put dividends in the denominator, but it is more common to deduct them from the numerator.

2)      The loan must be secured by sufficient and tangible collateral. Although business loans can be obtained with the business itself as the collateral. If a lot of the business value is due to the cash flow generating abilities of the business itself, most of that value will be gone in the case of a liquidation scenario. As a result, it is not uncommon to secure the loan with the pledging of additional collateral.

3)      The business buyer must show ability, experience, and provide substantial equity in the transaction.

Can a business buyer finance the purchase of a business with bad credit?

Your credit history is very important to a prospective lender. One of the first things someone looking for finance should do is to get a copy of their credit report, and make sure that it is fairly represents your history. Taking into consideration that you can get a copy of your report for free each year from each of the reporting agencies by visiting, there is no excuse for not doing this.

Most lenders will not lend money to borrowers with bad credit. However, there are exceptions to the rule. In my years of underwriting business loans, I have recommended a handful of loans to borrowers with bankruptcy filings still showing in their credit reports. However, it should be noted that those borrowers had satisfactory explanations for the bankruptcies, and their reports reflected their credit accounts were paid as agreed since the bankruptcy.

Can a business buyer finance 100% of the business acquisition?

In theory a business can be purchased with no money down of your own as long as the seller is willing to finance a portion of the purchase. In practice, most lenders will require the buyer to have some equity in the deal. It is possible to meet the equity requirements with a mixture of seller financing and cash. In those cases, the buyer will need at least 10% of the purchase price. Please note that although possible, it is very rare for a lender to be involved in a 100% financing scenario even with the benefit of a Sr. lien.

How is the financing structured when the seller is willing to finance a portion of the purchase?

The financing is structured a little bit different depending on whether or not the SBA is involved as a guarantor on the loan.  In both instances, the goal of the lender is to built in a safety cushion in the structure of the loan by not advancing more than 75% or 80% of the acquisition.  However, the SBA is very particular about not allowing any principal repayment during the term of the SBA guaranteed loan. Seller financing is always structured as a junior lien, and can be setup in three different ways:

1)      As a subordinated loan. Where principal and interest payments to the seller are made as long as he payments to the primary lender are current, and additional conditions are met. Some of the usual conditions are minimum debt service coverage ratio, minimum tangible net worth level, and maximum leverage ratios.

2)      Full stand-by debt (no payments of principal or interest for the term of the loan). This is usually a requirement to qualify the debt as equity for the purpose of qualifying for an SBA guarantee. Interest can accrue on the seller loan, but it will not be paid.

3)      Partial stand-by (interest payments are allowed). Also allowed by the SBA, and might allow the seller loan to count as equity.

What determines the value of the business for the lender?

For most transactions, the lender relies on third-party professional appraisers to provide business valuations. Only when the loan amount is small {usually $250,000}, does the lender decide to proceed with an internal valuation. It should be noted that as of the time of this article, the SBA required business valuation appraisals for all loans over $350,000.

The appraisals are mostly based on discounted cash flow analysis, but a good one will also assess the value of any assets owned by the business in excess of what is needed to produce the cash flow.

For more information about business loans and business valuations, you can buy these books from Amazon: Business Valuation For Dummies
and The SBA Loan Book: The Complete Guide to Getting Financial Help Through the Small Business Administration

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