Types of loans to buy a business

Small businesses are the backbone of this country, but starting one from scratch can be challenging. In fact, over 50% of new businesses fail by the fifth year. With daunting start up odds, more entrepreneurs are turning to buying a business instead of building one from scratch.

While the odds of a business acquisition succeeding are much greater, it does come with the drawback of being more expensive. The average asking price on BizBuySell is just north of $300K and many businesses are asking far more. 

Fortunately, there are various types of loans available to finance the purchase of a small business. In this blog post, we will explore the different types of loans, including SBA loans, seller financing, home equity loans, 401(k) rollovers, and personal loans.

1. SBA loans

The U.S. Small Business Administration (SBA) is a government agency that provides loans to small businesses through its partner banks. Among its various financing options is the 7(A) loan, which is a popular financing option for entrepreneurs buying a small business. SBA loans allow an entrepreneur to buy a business with as little as 10% down.

One of the main benefits of SBA loans is their availability for small businesses at relatively low interest rates. The average SBA loan is priced at prime plus 2-2.25% and carries a 10 year term. Securing a conventional loan on a small business acquisition is next to impossible, and for those that explore it, they will often find the rates are higher and the terms are shorter.

The drawback with the SBA program is that the application process can be lengthy and time-consuming. Borrowers must meet certain eligibility requirements, such as having a good credit score, providing collateral, and drawing up a strong business plan. These loans also require a personal guarantee by any person who owns more than 20% of the acquired business. Some lenders will go so far as to require a lien on your home, if your state allows it and their underwriting team asks for it.

Lastly, remember that SBA loans are issued by the banks, not directly by the SBA. Given that banks are for-profit, many avoid making loans to business acquisitions worth less than $400K. In their minds, it’s about the same work as lending to a business acquisition worth $1M and they stand to make a lot less money.

2. Seller financing

Seller financing is an arrangement in which the seller of the business provides financing to the buyer. This type of financing is involved in most small business acquisitions. The question is normally how much of the deal is seller financed. 

Most owners do not want to be “carrying paper” for years after the transition, especially if they are near retirement and not able to hop back in if things go south.

For acquisitions that use an SBA loan, typically buyers will use seller financing for around 10% of the deal. The resulting split is 10% down payment, 10% seller financing and 80% SBA loan.

For acquisitions that may not qualify for an SBA loan, either because of the buyer or the business, seller financing can be a key way to close the deal. We’ve seen transactions where seller financing accounts for up to 80% of the deal funds.

3. Home equity loans

A home equity loan is a loan in which the borrower uses the equity in their home as collateral. This type of loan can be a good option for homeowners who have significant equity in their homes and are looking to finance a small business acquisition.

One of the main benefits of home equity loans is that they typically have lower interest rates than many other types of loans. Additionally, the interest on the loan may be tax-deductible, which can provide additional savings for the borrower.

However, there are also drawbacks to home equity loans. First, the loan is secured by the borrower's home, which means that if they default on the loan, they risk losing their home. Additionally, the loan may require significant upfront costs, such as appraisal fees and closing costs.

Given the limited amount available to be loaned, home equity loans are more common with small deals below what your average SBA partner bank will lend to. We see them for transactions where the business is worth less than $250K.

4. 401(k) rollover

A 401(k) rollover is a type of loan in which the borrower takes a loan against their retirement savings to finance the purchase of a small business. This type of loan can be a good option for borrowers who have significant retirement savings but need additional funds to purchase a business.

One of the main benefits of 401(k) rollovers is that they do not require a credit check or collateral. Additionally, the borrower is essentially borrowing money from themselves, which means that the interest rates on the loan can be lower than those of traditional loans.

However, there are also drawbacks to 401(k) rollovers. For example, if the borrower is unable to repay the loan, they risk losing a significant portion of their retirement savings. Additionally, the IRS has strict rules and regulations governing 401(k) rollovers, and failure to comply with these rules can result in significant penalties and fees.

We recommend 401(k) rollovers for businesses worth less than $250K or where the buyer needs more cash for a downpayment. In order to stay compliant with IRS guidelines, please use a firm that specializes in 401(k) rollovers like Guidant Financial.

5. Personal loans

A personal loan is a loan that is issued to an individual and can be used for any purpose, including financing the acquisition of a small business. This type of loan can be a good option for borrowers who have a good credit score and are looking for a quick and easy financing solution.

The key benefit is that they can be obtained quickly, as the bank is not underwriting the business being bought. The bank is simply underwriting the buyer’s ability to repay the loan given their personal financial standing. 

The drawback of using a personal loan is that the interest rates are typically the highest and the repayment terms are the shortest. We normally see personal loans being used for a very small business where the buyer is confident that the cashflow of the business will allow him or her to repay the loan in 12-24 months.

Final comments

When it comes to financing the acquisition of a small business, there are many different options available. Each type of loan has its own benefits – speed, flexibility, and price - as well as drawbacks - application process, interest rates, and availability. We highly recommend considering these factors and others, as well as speaking to a financial advisor before making a decision.

Don’t forget that these are just the debt sources of financing. In addition to these financing options, entrepreneurs can explore equity roll-overs, raising capital from investors, and applying for local, state and federal grants.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.