The first thing to remember when preparing to buy a business is that no one wants to lend money to a business they think will go under. As a buyer, it’s essential to set goals and have a detailed plan of the business’s operations. Once a detailed plan and mitigation strategies are in place, it’s time to find a way to finance your business. Here we’ll take a brief look at various outside financing options and the benefits and risks that come with each choice.
1. Seller Financing
Seller financing can also be referred to as Seller Carryback Financing or Owner Financing. This type of financing is similar to a regular bank loan but the seller acts as the lender and the third party is cut out. Sellers often will loan anywhere from 15-40% of the purchase price. These loans are usually short term (5-7 years) as owners are generally not interested in collecting payments for an extended period of time. Contacts and promissory notes are drawn up to outline agreements, payment details, and consequences if payments are not made.
While some sellers may be hesitant to finance, their agreement to do so shows they care about the future of the business. Seller Financing allows for flexibility and negotiations in making a payment plan and reduces the time and cost of the closing process. However, not all sellers are willing to finance and a lot of trust is needed from both parties for this type of financing to work. In addition, several documents are required for this transaction to take place:
- Letter of interest
- Deal Contract
- Promissory Notes
- Security Agreement
- Bill of sale
- Bulk sale documents
- IRS Form 8594
- Consultation agreement (if the seller stays to help with the transition of the business)
- Non-compete agreement
- New lease for commercial property
- Transfer documents for vehicles, if they are involved in the sale
Related: What is Seller Financing?
2. Small Business Administration (SBA) Loans
An SBA is not the first place to check when looking for financing, as one of their requirements is that other financing options have already been exhausted. The SBA is a small business loan that is partially guaranteed by the U.S. government, where lenders provide the loan to small businesses. Due to duel entities (both government and lender) being involved in the lending of finances there are many requirements and criteria the applicant must meet to be eligible to apply for the loan. Basic requirements along with already exhausted other financing options include:Size of business - SBA loans are for small businesses only
- Must be a for-profit business
- Business must be in the U.S. or its territories - both the physical location and the operations
- The business owner must have invested equity
Along with lengthy terms and strict criteria, a couple of other drawbacks include long wait times for lenders to review your documents and the fact that lenders will often require collateral for larger loans.
However, there are many benefits that come with this type of loan compared to other loans: SBA loans are often more flexible and more manageable to payback. SBA loans also offer a smaller down payment with longer terms and they can be used to fund many different business activities.
3. Home Equity Line of Credit (HELOC)
A Home Equity Line of Credit is a loan where the lender agrees to lend money to the borrower, with the borrower’s house being collateral. HELOC ressembles a second mortgage but acts like a credit card.
This can be a good option for homeowners as HELOCs carry lower interest rates than credit cards because the loan is secured by a fixed asset. Securing a loan on a fixed asset makes it less risky for lenders, therefore they are likelier to lend more money.
A Home Equity Line of Credit can be taken to finance anything including:
- Buying a business
- Buying assets
- Paying wages
- Day-to-day costs
Lenders have formulas to establish a benchmark of how much money they are willing to lend, however, every lender is different so you’d be wise to apply to several lenders to find the best option for your particular situation. It’s also important to note that you should look at your personal finances to see what a realistic payment plan would look like for you. If you default on payments, the lender can foreclose on your house. As well, if you decide to sell your house, all payments to the lender become due immediately.
4. Home Equity Loan (HEL)
Home Equity Loans are a good option if you know how much money you need and you like following a strict monthly payback plan. Home Equity Loans come as a single lump sum payment and usually have a fixed interest rate that is lower than other personal loans because HELs are secure. Home Equity Loans can be used to finance anything substantial in value as most lenders will loan a minimum of $25,000. Similar to a HELOC, it’s important to ensure that you are capable of making the required monthly payments as your house is the collateral, and defaults in payments could result in the lender foreclosing your home.
5. Hard Money
Hard money loans are similar to Home Equity Line of Credit in the sense that they are both secured on a fixed asset. Hard money loans are often less desirable and should be a last resort due to their high-interest rates. With this type of loan, the amount of money the lender is willing to give you is not based on your credit score- in fact, lots of times your credit score is not even looked at. Lenders base their loans on the amount of collateral that the borrower can offer. These lenders use a ratio called a loan-to-value ratio and use it to measure the amount of risk they will acquire. Lenders will generally only loan approximately 70% of the value of the property.
6. A Personal Line of Credit and Credit Cards
A personal line of credit and credit cards are potentially two additional ways of obtaining the funds to buy a business apart from a traditional loan. With both of these options, there will be higher interest rates compared to a HELOC or a HEL because unlike those loans both of these options are not secured by an asset.
While a personal line of credit and credit cards have a lot in common, it’s important to point out some key differences when making a large purchase:
- Grace Period: a personal line of credit never has a grace period but credit cards do have a grace period except for on cash advances.
- Credit Limit: A personal line of credit generally has a lower credit limit than credit cards.
- Credit Limit for Cash Advances: is 100% on a personal line of credit and approximately only 20% on a credit card.
- Cash Advance Fee: There is no cash advance fee for a personal line of credit but for a credit card there is a cash advance fee.
- Rewards: A personal line of credit has no rewards while credit cards can come with various rewards except when used for cash advances.
So, depending on the amount of money you need, both options have the potential to help you obtain funds to buy a business. It’s important to take time and look at the many lenders and the different options offered to see which one fits your needs. If you decide to use a credit card, consider getting a separate credit card for your business to keep your business credit score separate from your personal credit score. A credit card can offer you what seems like an endless amount of money but there are high-interest rates if you aren’t able to fully pay your limits off monthly. Tracking your expenses and making payments on time is important as many small businesses do not have “commercial liability” and owners need to sign a personal guarantee meaning they are personally liable for the business credit cards.
7. Rollover for Business Start-ups (ROBS)
ROBs allows individuals to use an eligible retirement account to start or buy a business without incurring tax penalties or early withdrawal fees (if you’re under the age 59 1/2). Financing through ROBs allows entrepreneurs and entrepreneurs through acquisition to acquire finances without going into debt or using fixed assets as collateral. By doing this, you’re basically investing your retirement savings in your business. Profits from your business can be put into your retirement plan, tax-free.
Just like all financing options, there are some risks and there are requirements that must be met to qualify for a ROB. While you won’t lose your house or find yourself up to your neck in debt, you can end up losing all your retirement funds if your business fails. As for requirements individuals must have at least $50,000 in their retirement fund to transfer into their business fund. In addition, it generally costs around $5,000 to set up a ROB (which cannot come from the $50,000). Businesses also have to set up their company as a C corporation to apply for a ROB which can be quite complex and is not always the best move for every company.
8. Family and Friends
Borrowing from affluent family and friends can seem like a good idea- they want to see you succeed and they know how hard you work- but it may not be the best idea for everyone.
Of course, defaulting on loans from family and friends will not get your house foreclosed, nor will it result in constant emails in your inbox from lenders, but owing money to friends and family can be very stressful. Owing money to people you care about most can negatively impact the relationships you treasure most.
If you’re thinking of borrowing money from friends/family, ensure you clearly communicate with them the risks associated with your venture.
There are many different options for financing outside of traditional loans. There is no best route for the type of financing you should opt for when buying a business. All options have their pros and cons.
To be best prepared, do your research, identify the needs of the business you want to buy, and find the financial option that is best suited for your specific opportunity.