Buying a business | 8 min read

How to finance a business purchase

Last updated: November 18, 2019

Finances are often front of mind when it comes to buying a business, so it’s important to understand all the options and what will work best for you. The most common ways of making a business purchase are debt or equity finance – basically, getting a loan, or finding a business investor. Make sense of it all with this guide to the top ways to finance a business purchase.

 

What is debt finance?

In short, debt finance is money you borrow from an external lender. Generally, this means getting a loan from a bank, building society, credit union, or finance company.

Alternatively, you can get a loan that needs to be repaid from family or friends. If you’re exploring this option, seriously consider how this will affect your relationship and ensure all the details are well documented before any money changes hands.

When you borrow from a commercial lender (like a bank) you’ll get a set amount of credit. You’re expected to repay the money, with interest, within a set timeframe. For a business purchase, the amount you borrow will be fixed and the interest rate will depend on a variety of factors. These include who you borrow from, how big a risk the lender thinks they’re taking, and how much you need.

 

Advantages of debt finance

What’s great about funding your business this way is you’ll be in full control of your new business and will get any profits you make, rather than splitting these with shareholders. Plus, the interest you’ll pay in your loan repayments is tax deductible.

Every lender has slightly different requirements, but generally when applying for business funding with a bank you should:

  • work out how much you need, and why
  • prepare a detailed business plan
  • demonstrate you can repay what you’re borrowing by showing personal finance history and estimated income once you own the business
  • provide financial, management and forecast information of the business you want to buy.

 

Disadvantages of debt finance

An obvious drawback of debt finance, of course, is the loan will need to be repaid. Virtually all loans incur interest, so you’ll pretty much always end up paying more than the initial amount you borrow.

It can be tough to secure a loan if you’re just starting out as you’ll need to offer a substantial deposit first. You’ll also need to put up assets, like your house, or the company’s inventory, as security for your debt. This means if you can’t repay your loan on time, the bank or lender has the legal right to seize these assets.

Avoid having your assets taken by borrowing only what you need and work out whether you’re able to make the scheduled payments before you take out a loan. Assessing your personal funds and talking to an accountant is the best place to start.

 

What is vendor finance?

Vendor finance, also known as seller or owner financing, is when the person selling the business also loans funds for part of the purchase price. Essentially, the seller accepts an IOU from the buyer.

It’s most common when there’s a gap between the amount the buyer can afford to pay and the price the seller is willing to accept.

 

Advantages of vendor finance

Vendor financing can help you bridge the gap between the cost of the business and the amount you’re able to spend, without having to go through a bank or get an investor. It’s an especially attractive option if you’re having difficulty borrowing money from a bank or other loan provider.

Making your own arrangements with the seller generally means you’ll be in the business much faster than if you had to involve a bank or other stakeholders. This means you can take hold of the business immediately and start paying back the loan out of the business profits. If you work hard to successfully grow the business, you’ll be able to pay the loan back quicker.

An accountant can help you work out how much vendor finance you’d need to purchase a business and how to best structure the loan and repayments. As with any type of financing it’s essential that you have a loan agreement in place, which should be drafted by an experienced lawyer and signed by both you and the seller.

A vendor finance agreement generally includes:

  • how much is being borrowed
  • what the interest rate will be
  • the repayment frequency and amount
  • the type of loan (interest only, or reducing principal and interest)
  • any financial reporting requirements (like quarterly profit and loss statements)
  • what will happen if a payment is missed
  • what security will be provided.

 

Disadvantages of vendor finance

Most obviously, the biggest downside of vendor finance is that not every business seller will be open to providing a loan. While this is a common way of buying a business, sellers still typically favour other finance options. They may be open to vendor financing if it will enable them to sell to an otherwise qualified buyer and achieve their desired sale price.

Just like with a loan from a bank, you’ll need to provide an initial deposit and then pay back the remainder of the purchase price in scheduled installments, plus interest. You’ll need to have a good credit rating and demonstrate how you plan to pay back the loan.

The business up for purchase generally acts as collateral or security for the loan, meaning the seller will take back control of the business if payments are missed. In addition, you may also need to provide a personal guarantee for the loan.

If you think vendor finance is your best bet for buying a business, start by talking to an accountant to see if it’s really an option for you, then get some legal advice to understand any potential risks and obligations.

 

What is equity finance?

Equity finance is when someone invests in your business in return for owning part of the business. You don’t have to repay the money they give, but the investor will get a stake of your business and share returns from the profit you make.

Typically, equity tends to come from a private investor, or family and friends. Taking on a business partner generally means you’ll need to share any business decisions, so be clear on the details before you purchase anything.

It’s best to document your partnership with a lawyer. Your agreement should include how much you’ll each invest, the profit share amount and who handles what. Ensure you’re both clear on the terms of your agreement and understand the risks of investing in a business.

Also…do you have a plan? Because having a clear business plan in place will be critical to your business’s success and could help you convince a potential partner to invest. Just asking for money isn’t a great start to a partnership, so before you commit, consider how you’ll work together in the business. Think about the strengths and experience you can share with each other and how these might help you work towards success.

 

Advantages of equity finance

If you’ve chosen the right business partner, they’ll bring a network of contacts and connections and the potential to develop other strategic alliances. Searching for someone who already has experience in the industry could be advantageous.

Generally, there’s less risk associated with equity finance as you won’t owe any money. Not having a debt to pay back is one of the best things about funding your business this way.

You’re also not affected by interest rates or limited by how much security you can provide for a loan. Plus, you may be able to get additional investment to grow your business in the future.

 

Disadvantages of equity finance

For most, the greatest downside to equity finance is the need to share ownership. This can mean a loss of control when it comes to making business decisions, as well as added pressure for the business to succeed. If you’re getting into business to have full autonomy over your day job, the shared decision making that usually comes with having a business partner may not be for you.

The right partner will definitely be an advantage, but relationships can be tested when a business struggles. Particularly with investments from friends or family, seriously consider how business problems may affect your relationship before you dive in. Jumping into an arrangement with the wrong person can lead to business problems faster than you think.

You’ll also need to factor in time to research and find the right partner for your business and convince them to invest in your particular opportunity. This often isn’t a quick process and finding just the right business partner rarely happens overnight.

If equity finance sounds like the investment option for you, check out our top tips on how to find the right business partner.

 

Work out what’s right for you

Don’t simply grab the first finance option that comes your way; start by seeking advice from your accountant or a dedicated business advisor.

Evaluate all possibilities and do your research. Testing different financial scenarios can be a great way to see what will work best for your business and help you get a clear idea of what funding you need.

Remember, just as every business is unique, the best way to fund your business purchase will be whatever best suits your situation.

Check out the other steps involved in purchasing a business with our ultimate guide on how to buy a business.