So you want to buy a small business, but you don’t have the money? Don’t worry — there are ways to buy a business that don’t require having all the money upfront, just like there are ways to buy a house or a car without having all the money upfront.
However, financing the purchase of a business isn’t like financing the purchase of a car. Vehicle loans are commoditized to the point where you can pretty much walk into any car dealership, tell them your income, give them permission to pull your credit report, and then walk out with the keys an hour later. Business loans are not like that, and for multiple reasons.
Firstly, every business is unique. That means lenders will generally want to do a lot more situation-specific due diligence before they agree to give you money to buy a particular business.
Secondly (and often non-intuitively for the first-time business purchaser), the word “purchase” has two distinctly different legal meanings when it comes to purchasing a business. The first meaning is called an “asset purchase”, which essentially means you will set up your own LLC or corporation which will then purchase all the assets of the existing business. The second meaning is called an “equity purchase” which means you will directly purchase the equity (i.e. the stock of a corporation or the interest units of an LLC) of the existing business. Depending on whether you buy a business with an “asset purchase” or an “equity purchase” will affect whether some lenders will finance the deal or not.
In this article, I’ll go through seven different options to finance the purchase of a small business: SBA standard 7(a) loans, SBA 7(a) international trade loans, SBA 504 loans, CDFI loans, personal loans, bank loans, and seller financing.
1. SBA Standard 7(a) Loan
An SBA 7(a) loan is a type of loan which is provided by a normal financial institution such as a bank or online SBA lender but which usually has a lower interest rate than other types of business loans since the lender’s risk is mostly covered by a government guarantee. Do note that the guarantee does not directly help you the borrower, only the lender, but it does have the indirect effect of getting you a better interest rate and more likely acceptance of your application.
The SBA 7(a) loan is the most flexible loan of anything the SBA offers. You can get up to $5 million for a business acquisition, and that acquisition is allowed to be either an asset purchase or an equity purchase. You can even use a 7(a) loan to open a new franchisee business as long as the franchisor is listed in the SBA approved franchise directory. You can even get 7(a) financing for a combination of items including buying the business itself as well as inventory (which isn’t typically included in the sale of a small business), and working capital. However, there are a few rules you’ll need to follow in order to use this financing option.
Full Ownership Rule:
The borrower(s) must own 100% of the business after the transaction. The SBA 7(a) program does not lend to any person or group looking to only buy and own a portion of a business. If you already own 50% of a business and want to purchase the other 50%, then the SBA will help you do that, but if you just want to purchase a 50% stake in an existing business, then you’ll have to look outside of SBA options to find financing.
Required Down Payment Rules:
If you are purchasing a business in which you currently have no ownership stake, then you’ll need to put up 10% of the total purchase price & transaction costs. The SBA calls that money an “equity injection”, but it’s pretty much exactly the same as a down payment on a house or car. The seller can cover up to 50% of this equity injection via a loan from the seller to the buyer, but only if that seller debt is fully subordinated to the SBA 7(a) loan.
If you are purchasing a business in which (1) you already have an ownership stake, (2) your ownership stake has not decreased in the past 24 months, (3) you have been actively involved in the business for the past 24 months, and (4) the business balance sheets for the current quarter and most recently completed fiscal year both show a debt-to-worth ratio of no higher than 9:1, then your lender has the ability to reduce or waive the 10% down payment requirement. (Note: this is lender-specific, so if you satisfy each of the four requirements, you may need to shop around for a lender that actually reduces or waives the requirement).
Business Valuation: Internal vs Third-Party Rule
If the amount being financed exceeds $250,000, or if there is a close relationship between the buyer and seller (e.g. they are family members, business partners, or close friends), then the SBA requires a third-party valuation in order to provide 7(a) financing. However, if the transaction amount is less than a quarter million dollars, and the seller and buyer were not closely connected before the transaction, then generally the SBA does not require any third-party valuation of the business before providing financing.
Restrictions
The following types of businesses are generally ineligible from being financed with SBA 7(a) loans:
- Businesses involved in lending (e.g. loan packagers, hard money lenders, banks, finance companies, and leasing companies)
- Insurance companies (not agents, but the companies actually underwriting the risk)
- Investment or trading companies
- Investment funds
- Any business whose “stock in trade” is money
- Pyramid sales plans, regardless of the type of product espoused
- Gambling businesses (e.g. casinos, online gambling websites)
- Religious organizations
- Dealers of rare coins and stamps
- Cannabis businesses
- Any motel that permits prostitution
You can find additional information about eligibility and how to apply for 7(a) loans on the SBA’s 7(a) Program Info Page.
2. SBA 7(a) International Trade Loan (ITL)
The SBA offers a variation of the 7(a) loan called a 7(a) International Trade Loan (ITL). The terms for this type of loan are more rigid than the terms for a standard 7(a) loan. An ITL cannot be used to buy a business via equity purchase, and it cannot be used to purchase a franchise. However, it can be used to buy certain businesses via asset purchase.
In particular, ITL program loans can be used by an existing business to buy a second business via asset purchase under certain conditions. In order to qualify, the second business’ assets must primarily be facilities and/or equipment that enables the acquiring business to create or expand its international trade.
If you have an existing business and find a second business you’d like to buy that fits that description, then the ITL program can provide up to $5 million in financing with loan maturities up to 25 years if the assets acquired include real estate or up to 10 years if the assets acquired are only equipment, inventory, and/or working capital. You can find additional information about this loan option on the SBA’s ITL fact sheet.
3. SBA 504 Loan
SBA 504 loans cannot be used to buy a business via equity purchase, but they can be used to purchase businesses via asset purchase as long as the assets purchased are some combination of long-term fixed assets, machinery, equipment, or commercial real estate that will be used directly by the acquiring business. Unlike the ITL loan, none of the assets financed can be inventory or working capital, but on the positive side, 504 loans can be used to purchase almost any type of asset-centric business rather than just businesses related to foreign trade as is necessary for ITL financing.
504 loans can be used to finance asset purchase business acquisitions up to $5 million. To qualify for 504 financing, the buyer should (1) be a u.s. business rather than an individual, (2) have a tangible net worth under $15 million, and (3) have an averaged annual net income (after federal income taxes) of less than $5 million for the prior 2 years.
SBA 504 loans are not available directly from the SBA, but only through Certified Development Companies (CDCs). You can use the SBA’s official search engine to find CDCs near you, and you can find additional loan program details from the SBA 504 Loan Info Webpage.
4. CDFI Loan (only some CDFIs will do this)
Community Development Financial Institutions (CDFIs) are some of the least well-known resources available to small businesses. There are over 1200 CDFIs across all 50 states, DC, and even Guam and Puerto Rico, and these organizations exist to provide loans, grants, and financial guidance to start-ups, small businesses, co-ops, and real estate development projects.
CDFIs vary significantly from one to another. Most lend only to businesses or individuals in particular geographical regions. Some focus on lending to women, others to minorities, others to individuals with low incomes, and others will lend to any new business within their geographic region. Some (but not all) CDFIs provide lending options that can be used by individuals. All of these differences unfortunately mean that finding a CDFI that will work with you can be a bit of a search process, but the result can be very worthwhile as some CDFIs offer loans to people with less credit and experience than other lenders require, and sometimes (but not always) the interest rates and loan terms can be better than mainstream loan options. This web tool has a very useful search engine and map to locate CDFIs near you.
Some (but not all) CDFIs provide lending options that can be used to buy a small business. I haven’t seen any CDFIs that will finance equity purchases, but many provide loans to businesses to purchase assets, and this is where the opportunity is. If you have an existing business (or can quickly form one), then your goal will be to find a CDFI near you that provides loans for acquiring assets and then using that loan to buy another business via asset purchase.
5. Personal Loan
If you are interested in buying a business for under $100k and if you personally have good credit, a steady income, and not excessive debt, then a personal loan can be an excellent financing option. With an online lender, personal loans can often be approved within a week, and the money can be in your bank account within two weeks.
There are many online lenders which should be shopped for the best rates for personal loans. A few options include Upstart (up to $50,000), Lending Club (up to $40,000), and SoFi (up to $100,000).
6. Bank Loan
Banks don’t just offer home loans — they also offer business loans. If your credit is great and you have a steady income and low debt currently, then a bank loan can be a good way to obtain a loan to purchase a business. Talk to a few banks near you to see what they can do for you. Be aware however that this is possibly the most difficult financing option on this list as banks really only want to make business acquisition loans to people who have excellent credit, income, and debt levels. Most people would be better off going with either a personal loan or an SBA loan to finance a small business acquisition.
7. Seller Financing (take EXTREME CAUTION)
Seller financing is when the current owner of a business agrees to sell you their business and to loan you part or all of the purchase price. It is sometimes the holy grail and sometimes the trojan horse of business acquisition financing.
On the one hand, seller financing can often come with competitive interest rates, little to no money down, and less stringent credit requirements than other types of business purchase loans. This means seller financing can be an incredible tool for smart business leverage. On the other hand, sometimes the owner of a crappy business will offer seller financing to incentivize suckers to buy their business, take over liability payments, and provide them with a hassle-free income stream. If the buyer is eventually unable to make payments due to the poor quality of the business, the seller will just repossess the business and sell it again to a new sucker, all while keeping the payments the first buyer made up until they defaulted. Don’t be that sucker. How?
How can you distinguish the holy grails from the trojan horses amongst all the seller-financeable businesses for sale?
The first and most critical step is to consider the seller’s motivation, both for selling and for offering seller financing. Do as much due diligence as possible into the seller’s motivations.
If the owner says they are selling because they are relocating, ask enough questions to verify whether or not they actually are. If they really are relocating, try to figure out whether they are actually selling because they want to relocate or whether they are both selling and relocating because they couldn’t make their business work.
If the owner says they are selling to pursue other opportunities, then realize that the seller perceives the business they are selling as an opportunity not worth pursuing. If that’s the case for the seller, think very carefully about whether it’s an opportunity worth pursuing for you. In general, the answer should be no in this situation unless the business has a specific sort of problem that the current owner is not well suited to solve but which you are. For example, maybe the business works great internally but has terrible marketing. If you are a marketing wizard, then maybe this would be a good opportunity for you.
If the owner says they are selling to retire, then realize that the business is not currently in a state in which management can be outsourced. If the owner must sell a business to retire, then the owner is also a critical employee who hasn’t done a good job recruiting other people who can take over, otherwise they’d likely just keep the business as a passive revenue stream. The fact that they must sell means you’d be buying a job as much as you’d be buying a business.
Another important factor that can help you separate the holy grails from the trojan horses is where you sourced this acquisition opportunity. You should be equipped with the knowledge that most business brokers feed sellers unrealistic expectations regarding the fundamental value of their businesses, which means if you found a business for sale through a broker, it more than likely is overpriced and will be difficult to buy at a price that is actually advantageous to you. Furthermore, if a business is listed for sale with a broker AND is advertised as having seller financing available without you needing to specifically ask about it, then the seller is probably desperate to sell, which means the business most likely has some serious issues.
Oddly enough, one of the best ways to source good businesses to buy is to target businesses that are not actually listed for sale but which are having some problems you have the expertise to solve. There are three challenges you must overcome to make this work.
- You must find businesses that have some sort of problems but which aren’t listed for sale. This can difficult since the problems are often not apparent from the outside.
- You must convince the business owner to sell the business.
- You must convince the business owner to provide seller financing.
A great strategy to overcome all of these challenges at once is to have a B2B consulting business. Your consulting business clients will be the start of your business acquisition funnel. Clients will come to you with exactly the type of business problems you have consulting expertise with, which solves the first challenge. You can then negotiate terms that include equity compensation as payment to help them solve one of their problems. For example, you may ask for a 20% stake in their company contingent upon you helping them solve some serious problem in their business. If the problem is significant, the owner will likely accept this offer which gets your foot in the door for the second challenge.
After solving that first problem, if the business has other problems, you can ask the owner if they would be willing to sell you the rest of their company under a seller financing agreement. By solving one of their problems already, you have demonstrated your competence which means the owner now has reason to believe that you would be a good custodian of their business, that you could solve the remaining problems, and that you wouldn’t crash the business into the ground before they had received their full payout. Also, as someone who already owns equity in the business, you already have skin in the game which makes you more trustworthy as a business partner.