A business acquisition loan is a specialized type of loan and is generally used to buy an established (profitable) business. In some cases, an acquisition loan can be used to buy out a partner in a business. Additionally, franchise purchases may also fall into the category of a business acquisition since when you buy a franchise you’re technically getting a “turn-key” business operation. This is particularly applicable when the franchise is a well-known, national franchise with a proven record of success.
How Does a Business Acquisition Loan Work?
Like other types of business loans, you will need to provide documentation that shows your ability to repay the financing amount and demonstrate minimal risk to the lender.
Banks will generally start by asking you to show why you’re qualified to run the acquired business. For example, if you were a long-time employee of the company, this would be a strong indication that you understand the business. Or, if you operate a similar business and you’re trying to consolidate market-share, this would also be a favorable condition to demonstrate competence in operating the business.
Having access to the acquired company’s financial and banking records for several years and ensuring that they are in order is a must. Lenders will want to see that the company has steady business revenue. Selling a business can happen for many reasons, you should ensure that the reason they’re selling isn’t that it’s a failing business.
As a buyer, you will likely have to show your existing company’s financial records and several years of operations documents to show that you too are profitable and viable. This will likely include bank statements for several years, accounts receivable and tax returns.
While it is important to ensure that you can provide detailed financial records for both businesses, lenders are trying to gain a perspective on the overall picture. This may include viability studies depending on the business classification. A business acquisition can be just as complex and risky as a start-up. Don’t forget, you should be prepared with a business plan that shows how you will make your two companies stronger and more profitable, together.
Be sure to listen to the marketplace. If several banks reject your loan request, even if you agree to make bigger down payments you may want to re-evaluate the acquisition. Banks look to minimize risk, and they decline loan applications if they think the business venture is too risky to pay back the loan. Let this be a factor in your decision to move forward.
One of the more challenging issues in a business acquisition is assessing human resource requirements. This often means eliminating redundant work staff, consolidating vendors and shedding any redundant assets. This should be addressed in the transition section of your business plan. Keep in mind, even though you may have redundant assets like machinery our vehicles, these may prove more useful as collateral rather than the cash value of selling them. Check with your accountant and banker before you part with capital expense items.
Once you have your documents and plans in place, you need to assess your personal credit situation. Because acquisitions and mergers have a high rate of failure, banks may insist on a personal guarantee as a condition of making the loan. Remember, there are several ways to boost your credit score prior to applying for a loan. Examine your credit report for errors and dispute the erroneous items. Also, remember that all credit disputes must be responded to within 30 days in most cases; otherwise, the credit bureaus must remove them.
While it may seem odd, many savvy people will dispute all derogatory items on their credit report in the hopes that the companies who put them there will not respond. You may be surprised to know that it happens more than you think. Making a credit dispute costs nothing and regardless of the outcome it never has a negative effect on your credit score.
Another thing you will want to do is reduce the amount of debt that you have as soon as possible. If you are able, pay-off as much debt as you can two months prior to applying for a loan. Banks will look at your debt-to-income ratio to evaluate your creditworthiness.
Financing a Business Acquisition
Aside from banks, there are several popular ways that businesses finance acquisitions. One real safe way is to have the seller finance your acquisition. This can provide safety if you write your contract to cover any hidden or unexpected changes in the acquired business. This usually involves a higher overall purchase price, but there are many benefits to seller financing. Time to close on the acquisition can be almost immediate; seller will often provide support and guidance about the business since they want to see it succeed and little or no time filling-out loan forms and applications.
An SBA 7a loan is designated for business acquisitions. SBA loans are ideal (if you qualify) and have been turned down by the banks. One of the criteria of qualifying for an SBA 7a loan is that you applied for a bank loan and were rejected. With an SBA loan, a participating bank makes the loan and the government guarantees a portion of the loan in the event you cannot pay it back. SBA 7a loans can be up to $5 Million. The average SBA 7a loan amount in 2017 was about $372,000.
Although a bank loan is typically the first thing that comes to mind when you think about financing, for a business acquisition it’s not as common to walk right into your local branch and come away with a useful loan as you might think. That’s why programs like the SBA 7a loan can come in handy – to help give banks a little extra nudge in your direction.
No matter how you approach it, with a bank loan just be ready to go through all the normal paperwork and a bit of a longer process. Be prepared to show the following documents (for several years where applicable) when applying for one of these loans:
- Business Plan
- Business Tax Return
- Balance Sheet
- Personal Tax Return
- Bank Statement
- Business Lease Agreement
- Business Debt Schedule
- Business License
Valuation of a Business Acquisition
Assigning a value to the company you wish to purchase is a very important part of the financing process for a business acquisition. Valuations are often determined as a “multiple” of free cash flow or profits. This means that if you take the company’s current profits and multiply them by some factor, you can get the full value of the business. Like real estate, it would be wise to try to get comparable valuations from businesses in your industry that were sold recently. Your banker will likely have resources to help you determine this.
With everything taken into consideration, valuation can be determined by assessing tangible, fixed assets (ones that can be used as collateral); free cash flow, liabilities and debts and of course business profitability. For example, if you borrow $250,000 and the company is showing profits of $10,000 per year; that would take 25 years to repay. That would not be a favorable situation. Under $5 million, banks will generally look for repayment within 5-10 years when they’re financing it alone. SBA loans may have longer repayment horizons.
Once you’ve figured out where you can get the financing and which option is right for you, now you’re ready to pull the trigger and take over that great business you’ve been looking for. Keep those financing principles in mind and you should have no problem getting to that point.
Tim Kelly is a business leader and sales consultant who believes in strong communication as the kay to growth as a small business. He frequently writes for Biz2Credit and SmallBizStar.com and loves to share his insights on finance, marketing, and business growth with small business owners.