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The Pros and Cons of a Business Acquisition Loan
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Business acquisition loans can include multiple types of financing, including the 7(a) loan from the Small Business Administration, term loans, startup loans and equipment financing. They are essentially small business loans that can be used to establish a new business, assist in the operation, acquisition or expansion of an existing business, or purchase a franchise or business. But while there are a lot of advantages to business acquisition loans, they may not be right for everyone.
- Advantages and disadvantages of a business acquisition loan
- 4 ways to finance a business acquisition
- How to get a loan to buy a business: Business loan qualifications
Advantages and disadvantages of a business acquisition loan
Business acquisition loans can be a direct method of buying into a franchise or the buyout of an existing business. These kinds of loans can be used to finance the purchase of equipment, obtain and set up an office space or buy out existing owners, among other functions, and they can provide working capital while you get things up and running.
There are a few things to keep in mind before you decide to apply for a business acquisition loan, so let’s take a look at the pros and cons.
Pros of a business acquisition loan
There are multiple distinct advantages that come with small business loans, including the following:
- They can be used to finance portions of the business that are not secured by collateral. In many cases, banks secure loans with collateral like real estate, inventory or equipment to minimize their financial risk. Types of business acquisition loans that do this include some short- and long-term loans and equipment financing.The popular SBA 7(a) loan doesn’t require these assets, so if you don’t have them, that’s OK. You may be purchasing intellectual property instead of physical property, which business acquisition loans can help with. You can obtain up to $25,000 with this loan without needing collateral. We’ll discuss this more, below.
- They’re a long-term solution that can help you during the crucial early years. While there are short-term financing options available (including short-term loans), there are more long-term options available, including long-term loans, equipment financing and 7(a) loans from the SBA.Some business acquisition loans from the SBA are open revolving accounts depending on usage, allowing businesses to access available funds during set draw periods. There are also plenty of term loans that let you decide if you’d prefer a short- or long-term repayment schedule. SBA loans typically have maximum maturities of 10 years for equipment, 10 years for working capital or inventory loans and 25 years for real estate.
- The turnaround time can be fast. Most business acquisition loans have quick turnaround times, with some online lenders offering approval in as little as 24 hours, giving you more flexibility. While some SBA loans can take weeks or even months to receive, there are plenty of other lenders who have fast turnaround times.
Cons of a business acquisition loan
Like any loan, there can be some drawbacks to using a business acquisition loan to purchase a new-to-you business. Financing to purchase an existing business is a complicated decision, so carefully weigh these cons of business acquisition loans.
- Lenders rely more on cash flow and credit score. Any business acquisition loans (which can include the 7(a) loan and startup loans) that aren’t as heavily centered around collateral will have a bigger focus on cash flow and credit score. Lenders need to be more confident in your ability to pay back the loan. They’ll value your cash flow and personal credit score highly during the loan approval process, so for business owners struggling in either of these areas, it may be difficult to acquire this type of loan.
- Interest rates can add up. All types of business acquisition loans will come with interest rates attached, which can eat into your bottom line quickly. While you need the initial capital to buy the business, you’ll want to make sure that the interest rate isn’t so high that it keeps you from being profitable or eats into cash flow needed to scale your business further. Interest rates can vary, depending on the type of loan you’re seeking and the lenders you’re considering.
- Some types of business acquisition loans may have stipulations or restrictions. The 7(a) SBA loan, for example, requires that the previous owner doesn’t maintain any stake in the business, and that you’ve exhausted other financing options before pursuing the 7(a) loan. Any term loans or equipment financing may require collateral to secure it, so you’ll want to do your research carefully to determine what will work best for you.
4 ways to finance a business acquisition
There are multiple ways to finance a business acquisition, including non-SBA business acquisition loans. These are the 4 best loans to use to buy a business:
1. SBA loans
If you’re interested in acquiring a business, the 7(a) SBA loan to buy a business is a popular option.
SBA business acquisition loans are the industry standard, and they certify and work with multiple lenders. Terms range up to 25 years for the 7(a) loan, and you can borrow up to $5 million if you qualify.
SBA business loans also have the distinct advantage of having competitive interest rates. While the borrower can negotiate directly with the lender, all SBA loans have a maximum interest rate limit for both fixed and variable rate loans, which will be added onto the base rate (also known as the “prime rate”). For variable rate loans, these interest rates are:
- If the loan is $25,000 or less
- Less than seven years: A base rate plus 4.25%
- More than seven years: A base rate plus 4.75%
- If the loan is $25,000-$50,000
- Less than seven years: A base rate plus 3.25%
- More than seven years: A base rate plus 3.75%
- If the loan is $50,000 or more
- Less than seven years: A base rate plus 2.25%
- More than seven years: A base rate plus 2.75%
Fixed rates would be based on the prime rate plus around 5% to 8%. As of March 16, 2020, the prime rate is 3.25%.
There are a few downsides to the SBA loans, however. For example, the SBA takes the existing business’s credit score and financial history into consideration, so if the business is struggling financially, it may be more difficult to get this loan.
There are also prepayment fees to factor in if you want to pay your loan balance down as quickly as possible so you can reduce your debt. If you pay your 7(a) loan down too quickly, you could get hit with prepayment fees even if you save on the interest.
This is the case for loans with a maturity of 15 years or more, where you can get hit with 1% to 5% fees if you prepay 25% or more of the outstanding balance, or if prepayment is made within the first three years after the first loan disbursement.
2. Term loans
Traditional term loans are a strong choice for non-SBA business acquisition loans. You can acquire a term loan from a large number of lenders online, including banks, credit unions and online lenders.
Term loans simply give the borrower a set amount of funds, which will be repaid through fixed installments for the duration of the loan. This isn’t a revolving line of credit that you can continue to draw from; you get the funds upfront, and that’s it.
Rates can be variable or fixed for term loans, and for those with good credit scores, you may even be able to find rates lower than what the SBA offers.
Short-term loans will typically have higher interest rates than medium- or long-term loans, and most term loans are secured with collateral. You will likely be asked to sign a personal guarantee that holds you financially responsible if your business is unable to make payments.
Requirements for term loans vary from lender to lender. Term loans may require that the business has reached a certain profitability. They might also require that the business has been operational for a set period of time, which may range from several months to several years.
3. Startup loans
If you’re looking to acquire a franchise or a small business that hasn’t quite taken off yet, a startup loan may be a good option.
These loans are designed for new entrepreneurs and business owners in the very early stages of getting their business up and running, and they can be used to purchase a business. In many cases, a “startup loan” would be a 7(a) loan.
4. Equipment financing
Equipment financing is used for purchasing equipment for your new business.
A major advantage of equipment financing is that the equipment itself acts as the collateral, so you may not need to secure the loan with anything else. If you were to default on the loan, the financing company would simply take ownership of the equipment. For those just starting out and who might need to invest in equipment for the business, equipment financing can be a good option.
However, equipment financing really only works well if you need assistance covering the costs associated with buying new equipment or equipment from the existing owner. If you were to purchase a business whose value was primarily tied up in intellectual property like branding, or in premade inventory, this financing option wouldn’t work for you.
How to get a loan to buy a business: Business loan qualifications
If you want to get a loan to buy a business, you’ll need to meet multiple loan qualifications. It’s best to review whether or not you can meet these qualifications before you start applying so you can decide if the loan is a good option for you.
These qualifications include knowing the business valuation, getting a signed letter of intent, checking your credit scores and collecting the necessary financial documents.
Know the business valuation
While applying for a business acquisition loan, you’ll be asked about the valuation of the business you want to acquire. The business valuation determines how much the company is worth.
Lenders look at the business valuation carefully for business acquisition loans when assessing how much of a loan to approve you for. A small, local business valued at only $15,000, for example, may have a harder time convincing a lender to approve them for $350,000 right off the bat than a brand with a valuation of $75,000 or more.
Business valuation is a significant factor that lenders focus on during the approval process, because it helps them assess their risk, too. The higher the business valuation is, the less risky higher loan amounts become because there’s a much stronger chance that the lender will be paid back.
Business valuation can be calculated in different ways. The three most popular options are:
- A market-based valuation, which compares your business to other similar companies in your industry. This approach works best when your services, prices and operations are standard for your industry.
- An asset-based valuation, which looks at the net worth of a business’s assets. A restaurant, for example, may have expensive kitchen appliances, shatter-resistant dishes, pricey booths and tables and a large inventory of vintage wine. This approach can help the lender assess their risk in lending you money.
- An income-based valuation, which focuses on how much cash flow your business is estimated to generate in the future. While this is impossible to know for sure, a strong financial history with an upward projection for revenue is a good sign for lenders.
Get a signed letter of intent
It’s common practice for both the buyer and the seller of the business to sign a letter of intent, which typically outlines the specific steps that both parties will take in order to move forward with the arrangement.
Depending on how it is worded, a letter of intent may not be a legally binding document, but it shows lenders that you’re serious about moving forward. Lenders don’t want to give out business acquisition loans when there’s a solid chance that the deal won’t go through, so this can show them that you have a detailed plan and that the seller is on board, too.
An attorney can help you draft an SBA or standard letter of intent, which both parties will sign.
Check your personal and business credit scores
Lenders will look closely at both your credit score and the business’s credit score before they’ll approve a loan. They’ll want to know that you as a business owner are reliable and likely to pay back the debt, and they also want to ensure that the business doesn’t have a poor credit history.
To qualify for a business acquisition loan, you will need good personal credit. The minimum credit score accepted will depend on the lender and the type of financing you’re applying for.
You can receive approval for equipment financing with credit scores as low as 575, though many lenders have minimum requirements above 600. Some term loans lenders will accept credit scores as low as 500. To get a 7(a) loan, you’ll need a minimum of a 640 personal credit score, though having a credit score of 680 or higher can increase your chance of success. If you have a higher credit score, it may be easier to negotiate lower interest rates for the loan.
Many lenders (including those who work with the SBA) use the FICO Small Business Scoring Service score (SBSS score) to assess the business’s credit. This score is calculated based on an assessment of business bureau data, application information, consumer credit bureau data and the borrower’s financials. Borrowers generally need a minimum SBSS score of 140 to qualify for loans like the SBA’s 7(a) loan.
Business acquisition loans and bad credit don’t work well together, so if your credit doesn’t meet these requirements, you’ll need to look at alternative options.
Gather necessary financial documents
During the application process, you’ll need to submit a variety of different financial documents. The requirements will vary from lender to lender, but these are common business acquisition loan requirements that you can expect to see from most lenders:
- The loan application form
- Two previous years of federal income tax returns for the business you’re planning on purchasing
- A current profit and loss (P&L) statement from the existing business
- A proposed Bill of Sale, which must include the Terms of Sale
- The asking price and the schedule of inventory, equipment and furniture
- Personal background and financial statement (many lenders require a statement of personal history and a personal financial statement)
- Projected financial statements, detailing a one-year income projection with a written explanation of how you plan to reach it
- Information about the business’s ownership and any affiliations
- Information about the business, including data for business certifications and licensing
- Your loan application history
- Your personal and business federal income tax returns from the previous three years
- A personal resume for each borrower
- A review of the business and its history, which should include an explanation of why the loan is needed and how you’ll utilize it
Choosing the best business acquisition loan
There are numerous financing options to choose from when you’re looking at acquiring a business or buying into a franchise. The conventional 7(a) SBA loan is a popular choice for many, but term loans and equipment financing can also be a good choice, depending on exactly what kind of business you’re acquiring and how you intend to use the funds. Startup loans, on the other hand, are great for those trying to break into business ownership, particularly with newer entities that have potential for a lot of growth.
When assessing your options, make sure you look at all the factors involved, including loan repayment terms, restrictions on how you can use the funds, APR and more. Remember that it’s not just about meeting the minimum loan requirements; you want to make sure that the financing works for your needs, too.