Business acquisition financing: how buyers fund the purchase of an existing business

Buying an existing business can be quicker and less risky than starting from scratch: you inherit customers, staff, suppliers and a track record. The challenge is paying for it. Unlike a piece of equipment, a business is worth mostly what it earns, so lenders look at the cash flow of the company you are buying, not just at your own finances. This guide explains the main ways buyers in Canada and the United States put the money together.

It is general information, not legal, tax or financial advice. Deal structure and tax treatment depend on your facts, so involve a lawyer and an accountant before you sign anything.

The building blocks of an acquisition

BDC's guide on how to finance a business acquisition describes a purchase as a stack of layers. Each layer has a different cost and different repayment terms:

• Equity from you, from company cash or from an outside investor. BDC notes that equity lowers the amount that must be borrowed and shows lenders that the shareholders are committed.
• Senior debt, the largest and cheapest layer, secured on company assets and usually with the strictest repayment terms, such as monthly payments and financial covenants.
• Mezzanine or subordinated financing, which fills the gap between the price and the other layers. It costs more than senior debt but can have more flexible repayment.
• Seller financing, where the seller is paid part of the price over time.

BDC's worked example uses a $15 million purchase. Senior debt is $9 million, which BDC describes as three times EBITDA, mezzanine is $2 million, the vendor note is $3 million (20% of the price) and equity is $1 million: $9M + $2M + $3M + $1M = $15M. Your deal will be much smaller, but the logic is the same. Each layer reduces what the others have to cover.

A small illustrative example

These figures are invented to show the arithmetic and are not a lender requirement. Say you are buying a business for $600,000.

• Your cash (equity): $90,000, which is 15% of the price
• Seller note: $90,000, also 15%
• Bank or government-backed loan: $420,000
• Check: $90,000 + $90,000 + $420,000 = $600,000

Changing any one layer changes the others. If the seller will not take back a note, you need $90,000 more from the lender or from your own pocket.

United States: SBA 7(a) for a change of ownership

The SBA's 7(a) loan program lists changes of ownership, complete or partial, as an eligible use, along with acquiring a partial ownership interest in a business. You apply through a participating lender, not the SBA. The SBA's 7(a) terms and eligibility page lists a standard 7(a) maximum of $5 million and says 7(a) maturities are generally 10 years or less, up to 25 years including extensions when real estate is involved.

Two points matter for buyers:

• Equity injection. The pages we reviewed did not state a required down payment for 7(a) acquisitions. The detail sits in the SBA's Standard Operating Procedure (SOP 50 10 8.1 is the current version listed on the SBA site) and in each lender's policy, and both can change. Ask the lender what it will require before you make an offer.
• Seller notes. Whether a seller note can count toward your contribution, and whether it must be on standby, is set by the SOP and the lender. We did not read those rules in detail, so ask the lender directly.

The program also has eligibility rules. The business must be a for-profit operating business in the US that meets SBA size standards and is not on the ineligible list in 13 CFR 120.110. Our guide to SBA 7(a) vs 504 compares the two programs. If the deal includes real estate, see SBA 504 loans explained, because buildings are sometimes financed separately from the business itself.

Canada: BDC transition financing and other options

In Canada, BDC says its Growth & Transition Capital team can provide several layers of an acquisition: senior debt as a cash flow term loan, mezzanine financing that can be patient after the acquisition, and minority equity. Banks and credit unions also finance acquisitions. The Canada Small Business Financing Program can help with certain purchases of assets and improvements, though it is built around specific eligible costs, so see our guide on the CSBFP explained before assuming it fits an acquisition.

BDC also publishes a guide on the letter of intent and confidentiality agreement for an acquisition. It is worth reading before you start negotiating, because the letter of intent sets the structure that financing will have to match.

Seller financing (vendor take-back)

BDC describes seller financing, also called a vendor take-back or vendor note, as an arrangement where the seller agrees to be paid part of the purchase price over a period of time with interest. BDC says vendor notes usually carry few conditions and favourable interest costs, and that a seller who is still owed money has a reason to help the business succeed after closing. In BDC's example the vendor finances 20% of the price.

Why buyers like it: it reduces the cash you need at closing and aligns the seller with your success. Why lenders care: a note ranks behind the senior loan in most structures, and a lender may restrict payments on it if the business struggles. Agree the interest rate, term, security and what happens if the business misses a payment in writing, with a lawyer.

Earn-outs

An earn-out makes part of the price depend on future results. BDC describes it as a variable portion of the vendor note that can rise or fall with the company's EBITDA over the repayment period. An earn-out is useful when buyer and seller disagree on what the business is worth, because the seller is paid more only if the business performs. The risks are disputes about how results are measured, so define the metric, accounting rules and who controls operations in the purchase agreement.

Asset purchase vs share purchase: the basics

This is a general introduction, not tax advice. In an asset purchase you buy selected assets (equipment, inventory, customer lists, goodwill, and so on) and usually decide which liabilities you assume. In a share purchase (a stock purchase in the US) you buy the owners' shares in the company, so the company continues with its history and liabilities. Buyers often prefer assets for the ability to leave behind unknown liabilities, while sellers sometimes prefer a share sale for tax reasons. Contracts, permits and leases may need consent to be transferred in either structure. Which one is better depends heavily on your tax position, so get advice before you agree to a structure.

In the US, an asset deal has a filing consequence: the IRS instructions for Form 8594 say both buyer and seller must file the Asset Acquisition Statement when assets that make up a trade or business are transferred and goodwill or going concern value could attach. The form allocates the price across seven asset classes, from cash through inventory and equipment to goodwill, which sets the buyer's basis in each asset. Your accountant should handle this with you.

How the down payment (equity injection) works

Lenders want you to have your own money in the deal. The money may come from savings, the sale of another asset, an investor, or sometimes a seller note, depending on the lender and program. Lenders typically verify where it came from. A gift or a loan from a relative may need extra documentation or may not count at all, so ask early. If your cash is short, a larger seller note, an earn-out, or mezzanine or equity partners can fill the gap, as BDC's layering example shows. Be careful about borrowing the down payment from another lender: it increases your total debt and may breach the terms of your main loan.

Due diligence documents lenders commonly ask for

Every lender is different, but expect requests along these lines:

• Three years of business tax returns and financial statements for the target, plus current year-to-date results
• The signed letter of intent and, later, the draft purchase agreement
• A breakdown of the price by asset, including goodwill
• Your personal financial statement, tax returns and résumé showing relevant experience
• A business valuation or a lender-ordered review of the company's value
• Lease, key contracts, licences and permits, and customer concentration details
• Lists of debts, liens and equipment
• Source-of-funds evidence for your equity contribution

Our guide on documents lenders need covers the standard checklist, and how much your business can borrow explains how lenders size a loan from cash flow.

Common mistakes

1. Making an offer before talking to a lender. Ask what structure and equity they expect first.
2. Ignoring working capital. After closing you still need cash for payroll and inventory. Working capital or a line of credit may have to be arranged separately.
3. Skipping professional advice. Valuation, tax and legal mistakes in an acquisition are expensive to fix.
4. Relying on projections alone. Lenders weigh historical earnings far more than a forecast.

Where celerfunding.com fits

celerfunding.com is a referral service, not a lender. You can send us a request and we will tell you honestly whether we can introduce a suitable provider for this type of financing. We do not claim to have acquisition lenders in our network, and acquisition deals are often arranged directly with a bank, a government-backed lender or BDC. If we can introduce a provider, lenders may pay us a fee if the business is funded; business owners pay us nothing. We cannot guarantee any outcome. See our government-backed loans page, compare options or send a request.