Companies looking to increase sales, earnings, number of customers, or some other measure (like product or service offerings) have essentially two options – grow it or buy it. For reasons to be explored in a future article, let’s assume that our business owner decides to expand his or her service offering by acquiring a company instead of growing internally over time. Further, let’s assume the target company has few fixed assets, lots of goodwill and generates substantial cash flow.

This article focuses on financing the deal using a bank or cash flow lender who will seek repayment primarily through the business’ cash flows, instead of hard assets. Typically, for deals under $2 million, banks and cash flow lenders will use a government guaranteed loan program (through the Small Business Administration), and for deals between $3 million and $100 million, they may lend on cash flows up to 1.5 to 2.5 times Earnings Before Interest and Taxes (EBIT).

The following steps describe the general requirements and process of obtaining such a loan:

Step 1: Cash Requirement
In today’s environment, banks and cash flow lenders require a 20% down payment on the "project cost" defined as the agreed upon purchase price, plus borrower’s closing costs, plus any working capital request, plus other fees.

Step 2: Experience
Lenders like experienced buyers. Unrelated business ownership or employment experience with "transferable skills" may suffice in certain circumstances. If the borrower owns an existing ("affiliate") business, the lender may review its history and its ability to generate cash and to help determine the business management capability of the borrower.

Step 3: Collateral
Lenders typically require that any available assets need to be pledged as secondary sources of repayment for the loan and to demonstrate the borrower’s commitment to the project. Use of personal residences or other real estate is common.

Step 4: Credit
A good credit score is helpful to qualify the borrower for a loan. A business owner can pull his or her own credit score directly from the reporting agencies without incurring an "inquiry." The current limit on small business acquisition loans is $1,333,333. Other financing options and real estate financing programs are also available.

Step 5: Business Cash Flow
The business being purchased must provide enough cash flow to service the loan to support borrower’s personal cash needs. Some borrowers have spouses or affiliate businesses that provide sufficient personal cash. Most lenders require that cash flows from the business being acquired exceed the loan service by a factor of 1.25 for each of the last three years. Certain exceptions apply if the business was recently started. Adjustments are made to stated income by adding back depreciation, interest, and certain owner perks and discretionary expenses. However, creative add backs are not usually accepted.

Step 6: Business Plan and 12-Month Projections
The lender wants concrete evidence on how the borrower plans to operate the business. A short business plan (or operating summary) and a minimum 12-month cash flow projection usually suffice. Depending on the borrower’s industry experience, the lender may require more detail.

Step 7: Loan Application and Documentation
Each lender has its own application, but all contain similar requests including the items listed above. Additional documents typically required include: Management resume for each borrower/owner, Three years personal federal tax returns, IRS Form 4506 allowing the lender to obtain verification copies of tax returns from the IRS, A cash flow analysis similar to the one performed on the subject business, Personal financial statement detailing personal cash/income needs from the business being acquired, Personal balance sheet listing assets and liabilities. For each affiliate business owned (20%or more) by borrower the lender will require: Three years federal tax returns, Three years fiscal year ending P&L’s and balance sheets, Interim period P&L and balance sheet, Current A/R aging report, Current A/P aging report, Business debt schedule (listing long term liabilities and terms).

Step 8: Letter of Intent / Term Sheet / Purchase Agreement
Sometimes the lender will begin the application process with a signed letter of intent, but most prefer a signed purchase agreement.

Step 9: Closing
After the purchase agreement is signed and the loan application is submitted with all required documents, the borrower receives a conditional loan approval letter usually within a few weeks. The borrower signs the letter and submits a modest "packaging fee" to the lender who will assign the application to an internal processor.

The seller and/or buyer’s representative(s) will open an escrow account and send the purchase agreement to them. Lien searches and tax clearances will be ordered/requested and bulk sale requirements will be addressed (if appropriate).

The lender’s processor will review the application and generate a "needs list" which contains additional items needed by the lender (e.g., serial numbers for equipment over $500, vehicles titles, etc.).

If real property is to be used as collateral, a property appraisal will be ordered. A business appraisal may also be ordered. Other required third party services will be ordered and related fees collected from the borrower.

The lender will generate original loan docs to be signed usually within a week or so from this point.

The lender then funds within a few days. If there is real property collateral, the title company will record, then funds will transfer and the deal closes.

Step 10: Role of Intermediary
Business intermediaries (transacting companies exceeding $2 million in sales) have relationships with various lenders and understand their process, loan size restrictions, underwriting criteria, among other factors, thus ensuring the likelihood of a smooth and successful loan closing for a particular project.

This article was written to provide insight into the process of obtaining a business acquisition loan from a lender who will use certain criteria and methodology to create the best loan package for the business owner to finance the purchase of a company to achieve growth through acquisition.

Cole Preston, JD, MBA, AVA is a business intermediary with Vercor’s West Coast office. Cole specializes in corporate finance, business valuations, and pre-sale consulting for business owners in virtually all industries.