Business experience is critical when you are using bank financing to buy a business. There are two primary areas of business experience a lender is looking for:

Total project cost consists of the following:

  • Purchase Price of the Business
  • Fees and Costs associated with buying the business
  • Working Capital included in the loan

For example – if you want to purchase a business for $1,000,000, estimated fees and costs are $50,000, plus you want to include $50,000 of working capital. Then the total project cost is $1,100,000. To buy a business with bank financing you will need at least 10% of the total project cost in cash or $110,000. This is referred to as your “equity injection”. Keep in mind that 10% is the minimum amount of cash you will need. Depending on the business, a bank may require up to 20% equity injection. However, if you only have $110,000 in the bank, you do not have enough money to buy a $1,000,000 business.

1. Post-Closing Liquidity

In addition to equity injection, you will also need what is referred to as “post-closing” liquidity. This is the amount of cash you have on hand after you have met your equity injection. At a minimum, most banks will want to see that you have at least 50% of your equity injection in cash. So utilizing the example above:

  • Total Project Cost $1,110,000
  • 10% Equity Injection $ 110,000
  • Post-Closing Liquidity $ 50,000 (50% of equity injection)

So in the above example, you will need $160,000 in cash to qualify to buy a business with a purchase price of $1,000,000 (at a minimum!).  The stronger your post-closing liquidity, the stronger your application will be. 

 

2. Source

Your equity injection will ideally come from your savings, money market, or brokerage account (via conversion of stocks and bonds to cash), and you will have the funds on hand. If you have $50,000 in checking/savings, $100,000 in a money market account, and $100,000 in a brokerage account totaling $250,000 – you are a strong candidate to buy a $1,000,000 business.

If you are light on cash, there are a few options available to you; but these tend to weaken your application overall:

  • Gifted Funds – you can have a portion of the equity injection gifted to you. This is an ideal scenario if you are going to be short on post-closing liquidity. However, a few things to keep in mind:
    1. The funds truly have to be a gift, and the giftor will need to execute a letter stating the funds are in fact a gift.
    2. The maximum amount of equity injection you will want to obtain as a gift is 50%. Any more than this will significantly weaken your application.
  • Home Equity Line of Credit – you can utilize a HELOC to provide funds towards your equity injection, but there are stringent requirements if you plan to do so:
    1. You must prove that the repayment of the line of credit comes from a reliable source other than the business you want to buy. In other words, the cash flow from the business you are buying cannot be the source of the interest payments on the HELOC. This is known as “outside income” or income that is not tied to the business. For example – if you are buying the business, and your spouse is going to continue to work; that can count as outside income.
    2. While this is an option, it does weaken your application overall as these types of funds are considered additional debt.
  • Retirement Funds – it is possible to utilize 401K or other retirement funds for your equity injection. Again, there are stringent requirements if you do so:
    1. You will need to utilize a company specializing in ROBS rollover, such as Guidant or Financial or Benetrends, as this is a complicated process.
    2. A bank will not be able to approve your use of retirement funds for an acquisition. They will need to obtain additional approval from an unaffiliated third party. This will add time to the overall process, and there is no guaranty your use of the retirement funds will be approved.
    3. If your entire cash injection is coming from retirement funds, and you do not have any non-retirement cash or short-term investments you plan to convert – it is unlikely you will be able to obtain financing.
    4. While this is an option, it does weaken your application overall as these types of funds are considered additional debt.

Overall, cash in the bank, and the more of it that you have, significantly strengthens your application.