This is the third in a series of posts about buying a small business and how we purchased our first one. If you are catching this series mid-stream, I recommend you start at the beginning of the series with Buying a Small Business: Overview.
In the first post in this series, I covered the benefits and downsides of buying an existing small business. I also mentioned the fishing lure business that my wife was unenthusiastic about purchasing and that one week later, she found the perfect business to buy.
In the second post in this series, I talked about how you might go about finding a business for sale and establishing selection criteria. I also shared where we found our business and the selection criteria that we used. So, let’s continue our story.
In this post, I’m going to talk about how to finance the purchase of a small business. It’s something that you’ll need to start thinking about before you even start looking. If you don’t know how you are going to finance the purchase, then you won’t know what you can afford.
Small Business Loans Overview
If you have ever bought a house, then you already have a general understanding of what’s involved in buying a small business. Fundamentally, you will have to come up with some non-borrowed money to put into the purchase of the business. This is similar to the money you would use for a down payment on a house, which is called equity. I’ll talk about this in my next post.
The rest of the purchase (if any) will be funded with borrowed money. This is like a mortgage on a home and is generally called debt but in this case is a small business loan. Unlike equity, debt needs to be paid back with interest. However, you don’t have to have debt. It’s possible that you may decide to buy the whole business outright without borrowing any money, in which case you won’t have to worry about debt repayments.
If you are interested in buying a small business, then the government is your friend. They have created a very successful program run by the government’s Small Business Administration (SBA) called their General SBA Loan Program 7(a) to help people finance their entrepreneurial dreams. They encourage banks to make small business loans to qualified individuals to purchase qualifying businesses.
Here’s how the SBA program works. The SBA doesn’t actually lend you any money, they make loan repayment guarantees to banks that lend on their behalf. So, what does this mean to you? You need to find an SBA approved lender that you are comfortable working with.
They will let you know what criteria you need to meet in order to be approved to receive an SBA guaranteed loan. They will also let you know what criteria the small business needs to meet in order to get funded. If you meet the criteria and the business meets the criteria, then you can borrow the money. If you default on your loan payments in the future, the SBA will reimburse the bank for a portion of their losses.
It’s highly unlikely that any bank would lend you money to purchase a small business without the SBA guarantee. Normally, a bank would require 3 years of financials from you running the business before even considering making you any kind of business loan. Since you are buying a business, which will be new to you, by definition, you have zero financials to share.
Advantages of SBA Small Business Loan Financing
Since getting an SBA guaranteed small business loan is the only way to realistically borrow money from a bank, it is a fantastic program in facilitating the purchase of small businesses. In speaking with several business brokers, the vast majority of deals are completed with SBA financing in place.
Here are four distinct advantage to using SBA financing versus traditional bank financing:
- An SBA loan will lend you much more than a traditional bank loan, usually up to 80% of the acquisition cost, up to $5 million. Traditional banks usually only lend up to 40% or 50%.
- The SBA guarantees 75% of the loan amount, so the interest rate is usually lower than traditional bank debt.
- The loan is usually for ten years, which keeps the payments low.
- As long as you are making your payments, there are few other requirements. Traditional bank loans may require onerous reporting or cash flow provisions.
If you, and the business you want to buy, qualify for an SBA loan, it’s probably a pretty safe route to take.
Disadvantages of SBA Small Business Loan Financing
The SBA is not in the business of losing money. Consequently, you will likely need to provide as much collateral as you have as security for the loan. This includes your house, cars, bank accounts… What does this mean? If you fail to repay the loan, they can take your house, cars, bank accounts, etc… That’s pretty serious stuff, so you should not take it lightly.
There are also certain types of businesses that are easier to finance through the SBA. Namely, any small business that can be collateralized, i.e. that has assets that can be sold off in case of financial disaster. For the most part, businesses that are easy to finance with SBA loans are old-school brick and mortar type business. Think of buildings, inventory, etc., and you’ll be thinking about the types of small businesses that the SBA will fund.
Want to buy an e-commerce site? Sorry, no SBA financing. Want to purchase a great online media property? No dice. This is why, when I was laid off in 2015 and was looking for a business to purchase to replace my income, I was focused solely on old-school type businesses. I wanted to look for an online business to buy, but I couldn’t find any small business loans for that type of purchase. I’ll share a case study on that small business search at the end of this series.
They also don’t like to small business loans when investors are involved in the deal or when seller financing is involved in the transaction. I’m not sure exactly why this is, but that is what I was told by a few local banks. They like to have one borrower, which is you, and then put a lien on all of your assets in case they need to take them later…a little scary.
Many of these terms are negotiated between yourself and the SBA-approved lender, so criteria will vary depending on the bank and your own circumstances. I’m just sharing what I found to be true during our searches. Now, let’s talk about seller financing next.
Unlike buying a house, when you buy a small business it is not unusual to have the seller lend you money for the purchase. What? That’s right, especially with small business purchases, you may ask the seller to make you their own small business loan.
Even if you don’t need the money to buy the business, it’s not a bad idea to get seller financing. Here’s why. If, after buying the business, you find that the seller had seriously misrepresented something or simply “forgotten” to mention something material to the transaction, then you have leverage.
Perhaps the seller has agreed to be available to train you for 20 hours a week for a few weeks. If you still owe them $100,000 then it’s likely they’ll show up for training. Maybe they agreed to be available for questions for six months. Again, if you owe them some money, they’ll probably pick up the phone.
Once the seller has his or her money in hand, there’s no guarantee that you will ever see or hear from them again. In many cases that may be fine, but in other cases they’ve agreed to stick around for a little while. Having seller financing in place helps to make sure they keep up their end of the bargain.
Sometimes SBA-approved banks won’t want to work with you if you have seller financing in place as it can complicate the deal. Similarly, a seller won’t necessarily want to be second in line to get paid behind a bank’s small business loan if that’s how you’re going to finance the rest of the deal. Every bank, every seller, and every transaction is different, so you’ll just have to see what works for you and your lender.
I’m calling this section self-financing, but it’s really bank financing. I’m calling it self-financing though because you are borrowing money from yourself to close the deal. You can do this through a home equity line of credit (HELOC), a 2nd mortgage on your home or through credit cards (although I wouldn’t recommend that).
So, technically, banks are lending you the money, but you are getting the funds from lines of credit instead of from loans that are specifically intended for the purchase of a business.
Of all the self-financing sources, I prefer the HELOC (see Why HELOCs Are Awesome) for this purpose. Here are three reasons why they work well for buying a small business:
- The interest rate on a HELOC is very low because the loan is secured by the value of your home
- Aside from a minimum monthly payment, you can pay yourself back whenever you see fit
- In most cases, the interest paid on the first $100,000 of borrowing is deductible from your taxes
A second mortgage on your home is also a reasonable option, but you’ll have a fixed monthly payment and term to deal with. Credit cards are always a bad option because the interest rate is so high. I only mention them because they are technically an option, albeit a bad one. So, how did we finance the purchase of our first business?
What We Did
As you may recall, in December of 2009, my wife found the perfect business to run from home. You learned how we found it in part two of the series, but how did we pay for it? Since it was a relatively small business, we used my all-time favorite financing method, our HELOC!
No bank applications, no investors to convince. Just the stroke of a pen across a nice blank check and Voila! The business was ours. Now, the whole process wasn’t quite as easy as that, but the financing was.
In many cases, you’ll use a combination of debt and equity to purchase a business. In the next post in this series, we’ll talk about equity financing.
See the fourth post in this series at, Buying a Small Business: Equity Financing.
Did you realize that financing the purchase of an existing business was so similar to financing the purchase of a home? Would you risk your home and other assets to borrow money to buy a business? Would you ever consider using a credit card to buy a business?