Business Loan Terms: What to Know Before Buying a Business
When you’re planning to buy a business, understanding financing options and their terms are vital to making a successful purchase. There are different types of business financing, each with its own pros and cons. This guide will help you navigate the diverse business loans available to fund your acquisition and understand the key terms you’ll encounter during the financing process.
Types of Business Acquisition Financing
Common business loans include SBA loans, conventional loans, and seller financing. U.S. Small Business Administration (SBA) loans are government-backed and offer lower interest rates and longer repayment terms. Conventional loans from a traditional bank or credit unions aren’t as flexible. They tend to have higher rates and stricter requirements. Other options are commercial real estate loans, equipment financing loans, and business lines of credit, which have specific requirements for a small business owner. Seller financing is when the seller lets you pay part of the purchase price over time. It can have flexible terms and may be easier to get than a bank loan. When buying an existing business, many buyers successfully combine multiple types of financing - for example, using an SBA loan alongside seller financing to complete their purchase.
Loan Amount and Down Payment Requirements
When considering down business financing options, keep in mind that lenders typically require a down payment. The down payment amount can range from 10% to 30% depending on your creditworthiness, the type of business loan, the total loan amount, and whether it’s a startup or an established business. Down payments for a small business loan can come from personal savings, retirement funds, or investor contributions.
An earnest money deposit is often required during the small business financing process. It represents the buyer’s seriousness and intent and can impact the small business loan terms. The deposit can range from 1% to 5% of the purchase price, and the total amount is usually held in escrow and applied toward the down payment or purchase price at closing.
Interest Rates
Business loan interest rates are either fixed or variable. Fixed rates remain constant over the loan’s life, while variable rates fluctuate under market conditions. A variable loan program can potentially lead to lower rates, but greater uncertainty over a longer amount of time.
Average interest rates vary by loan type. SBA loans generally have rates ranging from 6% to 9%, while conventional loans fall between 5% and 12%. Both loan options consider the financial situation of the business, as well as the business needs. Seller financing often offers rates between 8% and 10%, but terms can be more flexible based on negotiations with the seller.
Repayment Schedules
Repayment periods define how long a borrower makes payments, and the schedule varies depending on the type and terms of the bank loan. Short-term loans usually require monthly payments with total repayment in 1 to 3 years, while long-term loans have a longer amortization period and may be outstanding from 5 to 25 years. Short-term loans often have higher monthly payments but lower total interest costs, while long-term loans have smaller monthly payments, but more interest is paid overtime.
In some cases, loans may have a balloon payment. This is where smaller payments are made during the loan term, but a large lump-sum payment is required at the end. Balloon payments are common in loans with shorter terms and longer amortization schedules. They provide lower initial payments, but require careful planning to manage the final payment.
Collateral Requirements and Personal Guarantees
Lenders often require collateral to reduce their risk if the business defaults on payments. Examples of collateral include real estate, equipment, inventory, or accounts receivable. The type of collateral can influence the loan terms, including the interest rates and repayment schedules. Higher-value collateral usually leads to more favorable terms. Lower-value collateral may result in stricter terms or higher interest rates.
In addition to collateral, many lenders require the borrower to make a personal guarantee, which means the individual agrees to repay the loan if the business cannot. A personal guarantee typically requires the borrower to pledge personal assets, such as a home or savings. This adds risk for the borrower, but can improve loan approval chances.
Understanding how collateral and personal guarantees affect loan terms can help business owners negotiate better financing. It’s important to ask about the possibility of removing these requirements as business credit, cash flow, and annual revenue improve. Businesses can also consider refinancing if eligibility requirements or their situation change. Always think about the long-term impact of both on your personal credit score and business assets.
Loan Fees and Closing Costs
Business loans have various fees and closing costs. Common fees include origination fees, typically 1% to 3% of the loan amount, for processing the loan, and appraisal fees for evaluating collateral like real estate or equipment.
For SBA loans, there are additional SBA guarantee fees, which range from 0.25% to 3.75%, depending on the loan size and term.
Some business bank loans may have prepayment penalties, which are fees for paying off the loan early. These penalties compensate the lender for lost interest and usually apply within a specific timeframe.
Loan Covenants and Conditions
Lenders often impose financial covenants to ensure borrowers maintain a stable financial position. A common covenant is the debt service coverage ratio (DSCR), which measures the borrower’s ability to repay the loan from its operating income. Lenders typically require a DSCR of at least 1.25.
Borrowers may need to provide regular financial updates, such as:
- Financial statements
- Tax returns
- Bank statements
Additionally, loan agreements may restrict business operations. A lender can limit the borrower’s ability to take on new debt, make large capital expenditures, or sell major assets. These conditions help lenders manage risk and protect their investment, which is important regardless of the type of financing.
Special Considerations
When acquiring a business, certain special considerations can affect loan terms.
- Working Capital: Sometimes added to the loan amount to cover day-to-day operations after the purchase.
- Seller Financing: Can improve overall loan terms by reducing the amount needed from traditional lenders.
- Industry Type: Riskier industries may face higher interest rates or stricter conditions.
- Business Valuation: Lenders compare the purchase price with the appraised value to ensure it's reasonable. A higher valuation can support a larger loan, while a low valuation may lead to stricter terms or even denial.
- Transition Period: Lenders may have specific requirements regarding the seller’s training and transition support period after the sale.
Get expert guidance on financing your business acquisition! Visit BizBuySell’s Finance Center to learn about SBA Loans from a dedicated SBA lending team, or explore our Learning Center for more information about financing your business acquisition.