Types of Financing Available to Buy a Business

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Seller Financing

Read about the issues surrounding a Business Owner's decision to provide financing to an individual who is buying the business in our Seller Financing post.

Retirement Funds

Read how you can access your retirement account without tax penalties to buy a business in our 401K Financing post.

SBA Loans

For information about SBA Financing and the amount required as down payment to purchase a business, read this detailed overview about SBA Financing from a Bank's perspective about The Process From Start to Finish.

Home Equity Loans

Home equity loans in Texas have no legal restrictions regarding how you use your loan proceeds. Therefore, this is an option for financing the purchase of a business. The State of Texas Office of Consumer Credit Commissioner regulates the credit industry and educates consumers and creditors. You can find complete information about Home Equity Loans in Texas here.

Conventional Commercial Bank Loans

Those seeking conventional bank loans will have more success if they have a large net worth, liquid assets, or a reliable source of income. Unsecured loans are also easier to come by if the buyer is already a favored customer or one qualifying for the SBA loan program.

Specific Uses of Commercial Bank Loans

To Finance Working Capital. Financing working capital is the primary area of lending done by commercial banks. This type of loan is granted to finance current assets such as accounts receivable and inventory and generally falls into two loan categories: the short-term demand note and the line of credit.

A Demand Note finances temporary working capital needs caused by fluctuations in accounts receivable and inventory.

A line of credit is extended for a period of one year and can be of a revolving nature to fund company growth by financing increased levels of inventory and allowing the borrower to carry higher levels of receivables. The line is secured and based on a percentage of accounts receivable and inventory. Sometimes real estate is used as additional collateral.

A line of credit is also used to finance seasonal working capital needs. This type of loan is intended to be self-liquidating through the sale of inventory and collection of receivables. It fills the gap between the time payables to suppliers are due and receivables are collected.

To Finance Machinery and Equipment. Term loans are often made for the purchase of fixed assets. In this case, all funds may be advanced to the borrower at once or according to an agreed schedule for the purchase of capital assets. Usually the asset purchased is pledged as collateral for the loan along with any other collateral that may be required. Theoretically, the loan is to be repaid from the stream of earnings generated by the asset being financed.

To Finance Real Estate. Loans made by banks to finance real estate are either interim construction loans or mortgages. Interim construction loans are extended to builders and developers to finance the construction of real estate projects. The loan is normally made on a short-term secured basis using a demand note. A commercial mortgage is granted for the purchase of land and buildings and is usually a term loan secured by the real estate being financed.

Eligibility. When a commercial loan application is reviewed by a commercial bank, many factors are considered in the credit decision. Of primary concern is the protection of the depositor’s funds in the institution. For that reason, the banker’s ultimate credit decision depends upon the degree of risk he or she perceives in making the loan. Anything the borrower can offer in the form of collateral or guarantees to reduce this risk improves the possibility of a favorable loan decision. Some of the factors considered are:

• The financial condition and profitability of the borrower and his or her capacity to repay
• The reputation and integrity of the borrower
• The management ability of the borrower
• The nature of business of the borrowing entity
• The bank's expected rate of return from the transaction
• Any potential for future relationships
• The bank's internal credit policies
• Conditions in the borrower's industry
• General economic conditions
• Regulations
• Collateral value

Banks take collateral in order to reduce lending risks. However, they do not make loans that can only be repaid from the liquidation of the collateral. Any collateral offered should be readily marketable, assignable and provide a sufficient margin. The margin is known as the excess of the collateral’s appraised value over the loan amount.

The two most fundamental financial considerations made by bankers when they review loan applications are cash flow and financial leverage, or total debt in relation to total equity.

Bankers view cash flow as the primary source for repayment of loans. Therefore, the business should demonstrate adequate cash generation ability from its normal operations to service its total debt payment. In addition, bankers prefer that companies not be highly leveraged because there is a greater portion of business risk taken by creditors in relation to ownership interests. For this reason bankers tend to look less favorably on businesses with a higher leverage than the average of similar businesses in their industry.

When a bank participates in financing a business sale, it will typically finance 50 to 75 percent of the real estate value, 75 to 90 percent of new equipment value, or 50 percent of inventory. The only intangible assets attractive to banks are accounts receivable, which they will finance from 80 to 90 percent.

The estimated rate of rejection by banks for conventional financing of a business acquisition is 80 percent or higher.