In the United States, many entrepreneurs looking to acquire a small business turn to Small Business Administration (SBA) loans as their primary funding option. SBA loans often feature lower interest rates and longer repayment terms than traditional bank loans, making them an attractive choice for many. Additionally, they are typically more accessible to borrowers with limited collateral and require a lower down payment. For great insights about SBA debt funding options, be sure to check out this Spaces episode we did on the topic.
While SBA loans are widely considered the best option for financing an SMB acquisition, some entrepreneurs face significant obstacles in accessing them. For instance, the deal size may be too large, the required personal guarantees too onerous, or strict limits on earn-outs and uses of supplemental funds may prevent borrowers from securing the loans they need. Borrowers need to factor in a lengthy application process and stringent credit score requirements, which can lead to significant delays. However, the proposed rule changes to the SBA 7(a) program are likely to make this debt funding option more accessible in the future. Current rules require buyers to purchase 100% of the business, while the proposed change would soften this requirement, making it easier for buyers and sellers to work creatively on deal structure. In particular, this change may make it easier to complete transactions involving industries with professional licensing requirements. However, even with this likely change, the SBA is not necessarily the best funding route for all SMB buyers. In this piece, we look at different ways entrepreneurs seeking alternative debt funding options for SMB acquisitions can leverage non-SBA options to help secure the necessary capital.
Acquiring with a Traditional Bank Loan
A traditional bank loan is one option to consider when seeking debt funding for an SMB acquisition without SBA support. This method can be particularly useful for buyers that struggle to meet the SBA’s rigorous lending criteria (or as a source of supplemental debt funding on top of an SBA loan, as long as the purpose meets the SBA’s criteria). However, securing a conventional bank loan can also be challenging for many entrepreneurs, as banks often require significant physical assets belonging to the company as collateral, large down payments ( +30%), as well as a strong credit score.
With a conventional term loan, the borrower receives a lump-sum disbursement from the financial institution, which is then repaid in fixed installments over a set time period. These loans tend to come with higher interest rates and fees than SBA-backed loans and typically have a repayment term of around five years. Approval for a term loan is based on similar factors as SBA loans.
Asset-based lending allows borrowers to borrow against assets of the company, with collateral including fixed assets, receivables, intellectual property, and inventory. Asset-backed financing is similar to a leveraged buyout, with the financing based on the value generated by the target company. An asset-backed loan is made on the basis that the assets of the target firm can be liquidated in the worst-case scenario.
While traditional bank loans are the most affordable form of external finance, securing them can be difficult depending on the sector of the target company. High-street banks have become more selective in recent years about the businesses they will lend to, but alternative lenders exist for those who may not meet traditional bank lending criteria. Providing more security to the bank in the form of debtors, stock, assets, property, etc. can increase the chances of securing debt funding.
When seeking a bank loan for a business acquisition, it’s important to shop around to find the best terms. It may be beneficial to start with your own bank, as they may be more motivated to provide favorable terms to retain your business.
Leveraging Seller Financing for Acquisitions
In cases where traditional bank loans are difficult to obtain or where private equity funding may come with too many strings attached, seller financing may be a viable option for entrepreneurs seeking to acquire a small business.
Seller financing, also known as vendor take-back loan (VTB), is a financing arrangement where the seller of a business provides financing to the buyer instead of the buyer obtaining funding from a financial institution. One of the main benefits of seller financing is that it can provide a bridge between buyers and sellers when there’s a disagreement on purchase price. Sellers can finance some of the difference between the two parties, where they get repaid if the company performs according to the seller’s expectations. Seller financing also allows the seller to remain involved in the business as a debt holder and to earn a coupon return on their investment, which is likely to be greater than they would get from investing their money elsewhere. The seller might also benefit from certain tax advantages if they choose to participate with a seller note.
Seller financing can take various forms, such as delayed payments, seller notes, and earn-outs. Delayed payments involve the buyer paying the seller over a period of time instead of in a lump sum. A seller note is a loan from the seller to the buyer, where the seller becomes the lender. Earn-outs are structured payments that are tied to the performance of the business after the acquisition.
One additional advantage of seller financing is that it can provide a quick purchase option. This is because the seller is already familiar with the business and may not require the same level of due diligence as a traditional lender would. Buyers should carefully consider the terms of the loan before accepting financing from the seller and should be aware of any limitations that may be placed on the seller’s involvement with the business post-sale.
Other Financing Options for Buyers to Consider
Mezzanine financing is a type of financing that combines elements of both debt and equity financing. It typically involves a loan that is subordinated to senior debt, meaning that in the event of default, the senior debt holders would be paid first. Mezzanine financing can be used by buyers to fund an acquisition or expansion, and it can be particularly useful when traditional bank financing is not available or when equity financing is too costly.
One of the main advantages of mezzanine financing is that it can allow the buyer to retain significant control of the business. This is because mezzanine financing typically comes with fewer restrictions on the business than traditional bank financing, which may require specific covenants (specific rules a borrower must abide by) and collateral. Mezzanine lenders are also typically willing to accept a higher level of risk than senior debt lenders, which can make it a more attractive option for buyers.
Mezzanine financing is most appropriate for businesses that have strong cash flows, as the lender will look to the cash flow of the business to determine the repayment schedule. Mezzanine financing can be expensive, as it typically comes with a higher interest rate than senior debt financing, but it may be less expensive than raising equity capital, which can dilute the ownership of the business.
Community Development Financial Institutions (CDFIs)
Community Development Financial Institutions (CDFIs) provide financial services, including loans to low income communities and people who lack access to other forms of financing. While the sums available from these institutions tend to be much smaller than loans provided by the SBA and larger banks, CDFIs can be a viable option for entrepreneurs looking to acquire companies under $500,000 in enterprise value. With access to financial instruments often heavily favoring people who are already wealthy, CDFIs can play an important role in increasing access to small business acquisition opportunities.
Crowdfunding and Peer-to-Peer (P2P) Loans
Crowdfunding is the process of raising funds from many investors through online platforms. There are two types of crowdfunding: equity-based and reward-based. With equity-based crowdfunding, investors invest in exchange for a share in the business, whereas reward-based crowdfunding offers non-monetary incentives, such as product discounts, to investors.
P2P lending involves borrowing money from individual investors rather than traditional financial institutions. Borrowers can access P2P loans through third-party online platforms that connect borrowers with lenders or by leveraging their personal network of interested investors. In both cases, the lender charges a service fee for the funding.
Crowdfunding and P2P lending options may come with higher interest rates than traditional bank loans, but they can offer greater flexibility in repayment terms and access to a broader network of potential investors. The success of these campaigns often depends on the strength of the business’s marketing and networking efforts. Therefore, a solid business plan and marketing strategy are essential before pursuing these financing options.
Keep in mind that each of the above options has its own advantages and disadvantages, so it is up to each individual to conduct sufficient research and choose the option that is best suited for their needs and financial situation.
Ultimately, entrepreneurs don’t have to be rich to buy a company, but they might have to take on a personal guarantee to do it with leverage. It is crucial to only invest the money that you can afford to lose and make prudent decisions about your own risk tolerance.
With careful planning and a bit of creativity, you can successfully acquire a small business and achieve your entrepreneurial dreams.