How to finance buying an existing business

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• The lender starts with cash flow, not the price
• One deal shows how add-backs decide the loan
• Your equity can include a seller note, up to a limit
• The example shows where the money comes from
• A price above the valuation must be made up with equity
• Assets or stock changes what you inherit
• Rules that shape the structure
• When buying with debt is a bad idea

The lender starts with cash flow, not the price

A lender sizes an acquisition loan on the cash flow it can verify. SBA says the lender must show that you can run the business. It must also show that cash flow repays the loan (SOP 50 10 8.1, Appendix 15). The asking price comes second.

Four things set the loan:

• The earnings the lender accepts, after it reviews your add-backs.
• The coverage ratio the deal must reach, which is 1.25:1 for most purchases.
• An independent valuation of the business. A price above it must be made up with equity.
• Your equity: at least 10% of the total project cost, with limits on what counts.

One deal shows how add-backs decide the loan

Add-backs decide whether a deal passes. Suppose you buy a business for $1,200,000. The seller reports $330,000 a year in owner earnings. The lender subtracts a $90,000 salary for a manager. That leaves $240,000 of EBITDA, meaning earnings before interest, taxes, depreciation and amortizationamortizationPaying a loan down on a schedule, so each payment covers interest and part of the balance. Full definition.

Add $50,000 for closing costs and working capital. The total project is $1,250,000. Equity of 10% is $125,000, so the loan is $1,125,000. Use a 10-year term at 10% for the arithmetic. Those are not quotes. The payment is $14,867 a month, or $178,403 a year.

• Earnings needed: $178,403 times 1.25 is $223,004.
• Earnings the lender accepts: $240,000. Coverage is 1.35. The deal passes.

Now suppose the valuation work rejects $30,000 of the seller's add-backs. EBITDA falls to $210,000 and coverage to 1.18. The deal fails. At 1.25, $210,000 supports $168,000 of yearly payments, or a loan of about $1,059,000. You must find about $66,000 more equity, or the price must drop.

Your equity can include a seller note, up to a limit

SBA requires equity of 10%, which cannot be reduced or eliminated on an initial acquisition (SOP 50 10 8.1, Appendix 15, Para. C.2.a). Equity is measured on the total project cost, not the price alone. In the example it is 10% of $1,250,000, or $125,000.

Equity can be cash you have not borrowed, including a gift. A personal loan counts only if you can repay it from a source other than the business. Your salary from the business does not qualify.

A seller note can count, with limits. Seller debt, standby debt and minority equity together can supply no more than half of the required equity injectionequity injectionThe money or assets you put into the deal yourself. . In the example that is $62,500, so you still need at least $62,500 in cash. The note counts only on full standby for the term of the 7(a) loan, with no payments of principal or interest. The seller financing guide works through both structures.

The example shows where the money comes from

Add up sources and uses to see the whole deal.

• Uses: $1,200,000 purchase price plus $50,000 of costs and working capital, or $1,250,000.
• Source 1, SBA loan: $1,125,000, or 90%.
• Source 2, your cash: $62,500, or 5%.
• Source 3, seller note on full standby: $62,500, or 5%.

An SBA acquisition loan can also be paired with a working capital line of credit (SOP 50 10 8.1, Appendix 15, Para. C.3.d). Ask the lender how the collateralcollateralProperty a lender can take and sell if a loan is not repaid. is shared between the two before you commit to the purchase price.

A price above the valuation must be made up with equity

The lender orders the valuation, and a price above it must be paid with equity. The valuation must come from a qualified, independent appraiser. A valuation prepared for you or the seller does not count. If the price exceeds the valuation, equity must make up the difference (SOP 50 10 8.1, Appendix 15, Para. C.1.a).

SBA's own guidance gives five examples of ways to value a business: capitalized earnings, excess earnings, cash flow, tangible assets and specific intangibles.

Two thresholds change the work:

• At or below $350,000, the lender may value the business itself, unless the buyer and seller are closely related.
• At or above $3,000,000 on an initial acquisition or business expansion, a Quality of Earnings report is also required.

That report reconciles statements, tax returns and IRS transcripts. It rebuilds cash receipts from bank statements. It also tests add-backs, owner pay, related-party deals and customer concentration (Para. C.1.b).

You pay for these reports, but money spent on them can count toward your equity.

Assets or stock changes what you inherit

You can buy a business through its stock or through its assets. SBA treats an asset purchase of all or substantially all of a business as a change of ownership. That applies if you continue its operations (SOP 50 10 8.1, Appendix 15, Para. A).

The choice changes your risk. In a stock purchase you generally take the company with its history and its liabilities. In an asset purchase you generally choose which assets and liabilities to take. Have an attorney and an accountant review the structure. See the answer on asset and stock purchases.

Rules that shape the structure

• The seller must leave. The seller may consult for no more than 24 months and may not stay as an employee or owner. This applies after an initial acquisition or business expansion.
• Seller earnouts are prohibited. Rebates to you based on performance are allowed.
• Maximum term. 10 years of amortization, with only the real estate portion allowed up to 25 years on a blended basis.
• Projections do not count. The lender must evaluate your post-closing projections but cannot rely on them to meet coverage. The exception is an owner-occupied Special Purpose Property (Appendix 15, Para. C.2.b).
• The seller's returns get checked. The lender verifies them against IRS transcripts before relying on them.

When buying with debt is a bad idea

• The earnings walk out with the seller. If customers follow the owner, the add-backs vanish. SBA lets the seller consult for only a short period.
• One customer pays most of the bills. A Quality of Earnings review tests customer concentration risk.
• Coverage sits at the minimum. A 20% drop in earnings takes 1.25 to 1.00, where cash flow equals the payments. Leave room.
• The price rests on add-backs you cannot document. The lender must justify each one in writing. Add-backs without that analysis do not count (Appendix 15, Para. C.2.b).
• Your own pay is not covered. Your pay as owner must support your current obligations and living expenses. A business that pays the lender but not you fails the global test.