Business Loan Requirements: Understanding Lender Expectations in Business Acquisitions
From small business loans to business lines of credit and term loans, business owners have many financing options. As a business owner looking for working capital or funds to purchase a business, it’s important to understand the various loan options, as the terms and lender’s requirements may vary. For those looking to finance the purchase of an established business, understanding the requirements will help entrepreneurs navigate the acquisition process more effectively.
What Do Lenders Consider?
When a borrower applies for a business loan, lenders will examine several factors before deciding whether or not to approve it. Your personal credit score can impact the decision, but it’s not the only eligibility criteria. For business acquisitions, lenders will be particularly interested in your plans for the transition and how you intend to maintain or improve the business’s performance post-purchase.
Who Are the Buyer and Seller?
When you're seeking a loan to buy a business, lenders will want to thoroughly evaluate both you as the buyer and the current owner as the seller. Here's what they typically consider:
The Buyer (You)
Lenders will want to get to know you before deciding to finance your business purchase. They'll likely assess:
- Your business acumen and management skills
- Previous experience in the industry of the business you're buying
- Your preparedness to take over and run the acquired business
- Your personal financial history and credit score
- Your vision for the business post-acquisition
The Seller
Lenders will also want to evaluate the current business owner and the business itself:
- The seller's reason for selling the business
- The business's financial health and performance history
- Market position and growth potential of the business
- Any outstanding debts or legal issues
- The transition plan from the current owner to you
Most lenders will conduct a thorough assessment of the seller's financials to determine if the business is a worthwhile investment. They'll want to ensure that the business has been profitable, has a solid customer base, and shows potential for future growth under new ownership.
Remember, from a lender's perspective, a business acquisition loan is an investment in both you and the business you're buying. Your job is to convince them that this investment is sound and that you're well-equipped to make the business thrive under your ownership.
Financial Statements
It should come as no surprise that profit and loss statements, income statements, and cash flow reports are a requirement for business loans. Most lenders will ask for these financial documents to closely scrutinize the health of your business and check whether your business is consistently profitable.
Of course, you won't have financial statements if you don’t have a business yet or are still in the startup phase with a thin credit history. Luckily, some financial institutions will consider solid forecasted financials, but will impose higher interest rates or request a personal guarantee to offset the risk.
When acquiring a business, lenders will scrutinize both your financial statements and those of the business you’re planning to purchase. They’ll want to see that the target business has a history of profitability and stable cash flow.
Debt Service Coverage Ratio
Your Debt Service Coverage Ratio (DSCR) can impact your ability to secure business financing. Most lenders want to see that your business can cover its debt with its current income. A good DSCR means your company has a cushion and is less likely to miss loan payments.
Debt-to-Income Ratio
For personal or consumer loans, lenders check your debt-to-income ratio (DTI) to assess your ability to repay the loan. The DTI compares your income versus your debt. A lower DTI suggests you’re less risky because you’re not overloaded with debt.
Seasonal Businesses and Cash Flow
Lenders will review your business’s overall cash flow to understand if your company can meet its debt obligations during slower months. This is especially important for seasonal businesses. Lenders want to be reassured that you can meet the loan terms throughout the year.
Buyer Financial Documentation Needed
If you’ve ever applied for a car loan or mortgage, then you know that lenders require financial documentation. Same goes for a business loan. These documents help them assess your ability to repay the loan.
While the type of business loan you’re applying for can influence the business loan requirements, here’s what traditional banks and small business lenders typically ask for.
If you’re buying an existing business, be prepared to provide a detailed business plan that outlines your strategy for the acquired company. This helps lenders understand how you plan to ensure the business’s continued success under your ownership.
Personal Credit Score
Your personal credit score is typically one of the first things traditional lenders check. A good credit score suggests that you’ve managed your finances well and can likely be trusted with a loan.
But don’t despair if you don’t have good credit. Online lenders are typically more lenient, with some even specifically serving those with less-than-ideal credit scores.
If you have a well-established business, you’ll most likely have a business credit score with credit bureaus like Equifax, Experian, or Dun & Bradstreet. The better your score, the better your chances of securing reasonable loan terms.
Tax Returns
Be prepared to produce several years of tax returns. They give lenders insights into your financial situation, including how much income you’ve reported and whether you’ve consistently paid your taxes.
Income Documentation and/or Cash Flow Statement
You’ll need to provide proof of income, such as pay stubs or a cash flow statement. This helps the lender see whether you have a stable source of income or consistent cash flow to cover loan repayment.
Outstanding Debt
Lenders will also look at your existing debts. They want to know how much debt you’re already carrying because it affects your ability to repay the loan. The lower your outstanding debt, the better.
Seller Financial Documentation Needed When Acquiring Business
A lender will want to review the financials of the business you are planning to buy to assess its health and determine if it’s a reliable risk. Pay close attention to these documents, as they not only inform the lender’s decision but also your own assessment of the business’s value and potential. You may be asked to provide some of the following.
Financial Statements
Lenders will want to see the business’s financial statements to evaluate its profitability and economic stability. They’ll look at income, balance sheets, profit margins, and cash flow to understand how well the business performs.
Business Tax Returns
Just like personal tax returns, business tax returns give lenders insight into a business's financial track record. They show whether the company has been profitable and reported income.
Business Bank Statements
Lenders may ask for business bank statements to review cash flow and day-to-day operations. They want to ensure enough money is coming in to cover current expenses and future loan payments.
Business Credit Score
A business credit score is important because it shows lenders how well the business has handled credit in the past. A higher business credit score can improve the chances of loan approval and better repayment terms.
Preparing for a Business Loan
Getting a business loan can help you start, grow, or expand your business, so it’s essential to be thorough. Being well-prepared can improve your chances of getting your desired loan amount and ensure the application process goes smoothly. When preparing for an acquisition loan, it’s important to have a clear understanding of the business you’re purchasing, including its market position, growth potential, and any challenges it may face.
Consider Working with Experts
Before applying for a loan, consulting with professionals such as a business broker, accountant, or attorney is a good idea.
- A business broker: Can help you understand business valuation and guide you through the purchase process.
- An accountant: Can assist with gathering, refining, and preparing financial documents, as well as help with profit, expense, and cash flow projections.
- An attorney: Can review contracts and legal documents related to the loan agreement to make sure everything is legally binding and protects your interests.
Although working with experts is not required, it can give you peace of mind that your business loan application is complete and nothing is overlooked.
Down Payment
A down payment shows your commitment to the loan and willingness to put your own money on the line. And since some lenders require a down payment, you must consider how you’ll come with the money if you don’t have it in the bank. The down payment size can vary based on the lender’s review of your financials, as it can reduce the loan size or change the terms.
Collateral or Personal Guarantee
When buying a business, lenders often require additional security to mitigate their risk. This typically comes in the form of collateral or a personal guarantee.
Collateral
Collateral is a specific asset that the lender can claim if you default on your loan. For business acquisitions, this might include:
- The assets of the business you're purchasing (equipment, inventory, real estate)
- Your personal assets (home, investments, savings)
- Accounts receivable
- Other business or personal property
Personal Guarantee
A personal guarantee is a promise that you'll repay the loan personally if your business can't. This means your personal assets could be at risk if the acquired business fails. Most lenders require a personal guarantee for business acquisition loans, especially for small to medium-sized businesses.
SBA Loans for Business Acquisitions
Small Business Administration (SBA) loans are a popular option for financing business purchases. Here are key points to know:
- SBA 7(a) loans: The most common type for business acquisitions.
- Guarantee requirement: SBA loans typically require a personal guarantee from anyone owning 20% or more of the business.
- Collateral: While the SBA prefers secured loans, they can sometimes approve loans without full collateral if other aspects of the application are strong.
- Down payment: SBA loans for acquisitions usually require a down payment of 10-20% of the purchase price.
Other Considerations
- Unsecured business loans exist but are harder to obtain for acquisitions and often come with higher interest rates or shorter repayment terms.
- Some lenders may use a combination of collateral and personal guarantees.
- The strength of the business you're buying can influence collateral requirements. A business with strong financials and assets may require less additional collateral.
Remember, while providing collateral or a personal guarantee increases your risk, it also demonstrates your commitment to the lender and can help you secure more favorable loan terms for your business purchase.
Alternative Financing Options
Business loans through traditional lenders is only one of many financing options. Depending on your business and needs, there are alternative financing options which may be a better fit.
- Seller financing: Often used in business acquisitions, this option can demonstrate the seller’s confidence in the business’s future performance under new ownership.
- Earnouts: These can be particularly useful in acquisition deals where there’s uncertainty about future performance, allowing you to tie part of the purchase price to the business’s post-sale results.
- Investors/partners
- Peer-to-peer lending
- Grants and government programs
- Friends and family funding
Find Your Next Business
Understanding the key factors lenders evaluate when reviewing your business loan application is critical for securing financing.
With more knowledge about business loan requirements, you’ll be better prepared to secure financing for your business acquisition and take the next step in your entrepreneurial journey.
Visit the BizBuySell Finance Center or Learning Center to learn more about how to finance your purchase or prequalify your business for sale.