How Do Acquisition Loans Work?

• Acquisition loans are used to help business owners acquire another business's assets or even entire companies.
• Acquisition loans come in several varieties, from conventional term loans to revenue-based loans, and lines of credit.
• Generally, acquisition loans use the acquired assets as collateral to secure the loan.
• This article is for business owners interested in using an acquisition loan to expand their business and acquire new assets.

Acquisition loans are loans that businesses use to acquire other businesses or strategic assets, such as equipment. These are purchases that can't typically be made using the company's normal cash flow, so businesses use loans to make the purchase without having to raise capital. Using an acquisition loan, your company can make large strategic purchases with as little as 15% down, then pay off the balance over time.

Acquisition loans are extremely common for companies that are growing quickly as well as those actively engaged in mergers and acquisitions. They're also sometimes used by companies that utilize large or expensive equipment, like construction companies, data storage providers, or large contractors. Acquisition loans help these businesses acquire crucial assets (including other companies) that can help them grow their bottom lines.

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What is an acquisition loan?

An acquisition loan is a loan that businesses use to acquire an asset or even another company. Some (but not all) acquisition loans are used when the asset being acquired will be the collateral for the loan – this is especially helpful when your business doesn't have sufficient value to secure a loan with separate assets.

Most acquisition loans require you to provide a down payment to fund part of the acquisition. SBA loans, for example, require as little as 15% of the total transaction value as a down payment (also known as an "equity injection"). Depending on your business, the loan type, and the asset you are purchasing, the lender may require a down payment of 20% to 30% of the total transaction.

In some cases, lenders may require less than 15% down, but they may also charge higher interest rates or offer less favorable terms. [Need Advice?: Tips for Negotiating a Business Loan] 

Key takeaway: An acquisition loan is specifically designed for the purpose of acquiring another business's assets or the company itself.

Types of business acquisition loans

There is no one specific type of acquisition loan for businesses. Instead, there are several types of business loans that can be used to acquire other companies, including term loans, lines of credit, government-guaranteed loans and startup financing. Each loan type has different benefits in different circumstances, though not all are appropriate for every organization.

5 types of business acquisition loans

The terms and qualifications of each of these small business loan types vary significantly, with each one having distinct advantages in certain situations. Some offer lower interest rates or fewer fees, while others offer interest-only payments, longer repayment terms, or increased flexibility.

Small Business Administration (SBA) loans

SBA loans are business loans that are partially guaranteed by the federal government. The SBA offers multiple loan programs, but most SBA loans are term loans. These loans often offer the best interest rates available for business owners who don't have ideal credit and allow them to finance transactions with as little as 10% down.

Plus, with SBA loans, part of the loan is guaranteed by the federal government, and this limits your liability if you later default – though it also involves an extra fee of several percentage points of the amount being guaranteed.

SBA loans are generally fairly flexible and can be used for various types of acquisitions. For some types of purchases, loan terms can last up to 25 years.

Conventional term loans

Conventional business term loans are those that a business can obtain through a bank or other traditional lender. These loans typically offer the best terms available – including the lowest interest rates – for borrowers who qualify.

However, these loans are probably the hardest to qualify for. This makes them ideal if you have excellent credit and plenty of free cash flow to service your business loan – even more so if you have established banking relationships with lenders who offer this type of financing.

In addition to the lowest interest rates, conventional business term loans typically offer some of the lowest fees available, since they don't charge the guarantee fees that SBA loans do.

Did you know? Conventional term loans usually have the best terms. However, they are difficult to qualify for and often take a longer time to provide funding.

Startup loans

Where most commercial loans require businesses to have been operating for at least a year or two, startup loans are better for companies that are still getting off the ground. These loans usually have a consolidated application process – even through the SBA – because there isn't as much information to review about company finances. Fees may also be lower, since most startups don't have the funding to pay large fees.

Startup loans are riskier for lenders than many other types of business loans, so interest rates may be higher than those of conventional term loans or business lines of credit, but rates are still lower than those charged by business credit cards.

One other thing to note about startup loans is that some programs limit borrowers to smaller loan amounts than those available through some other loan programs, though the cap for SBA startup loans is $5 million through the agency's 7(a) program. Depending on which program you use, this may limit the size of acquisitions you can complete. But this may be sensible, since many companies that are just starting up haven't yet established the cash flow necessary to support large loan balances.

Business lines of credit

Business lines of credit (BLOCs) aren't often used as acquisition loans, but in certain circumstances they can be ideal for that purpose. These loans are revolving, meaning that once you get approved for up to a certain amount (your credit limit), you can borrow that money anytime you need it during your draw period.

Once you draw against your line, you only pay interest on the money you actually borrow (monthly interest-only payments), and you can repay your balance as you choose. If you pay down your line within your draw period, you can borrow those funds again without going through another application process.

Interest rates for business lines of credit are usually slightly higher than fixed term loans' rates, but you get a lot more flexibility with BLOCs than you do with term loans.

Once your draw period ends, your line of credit can typically be converted to a structured loan with fixed monthly payments, so you can pay off the balance over several years.

Revenue-based loans

Revenue-based loans are structured with flexible payments, which are calculated as a percentage of monthly revenue rather than being fixed. With a revenue-based loan, you get a lump sum upfront, and then the lender takes a percent of your business's revenue until the loan is repaid with interest – similar to a merchant cash advance.

Because revenue-based loans have a variable repayment structure that represents more liability to lenders, they often charge higher interest rates than other loan types do. But these loans also reduce drawbacks to you as the borrower, because if your business has a slow month, your payments are lower – rather than you running the risk of defaulting.

How do you qualify for an acquisition loan?

Qualifying for an acquisition loan is mostly the same as qualifying for any small business loan. You need to identify a funding need (or a likely funding need, if you're just trying to line up financing before identifying a target asset to acquire).

Once you know your reason for borrowing, you need to pick the right funding type for your business's circumstances, and then pick a lender that specializes in that type of financing. For example, if you want to get an SBA loan to buy a new facility, you should pick a bank or loan broker that has underwritten a lot of SBA loans and had success getting them approved.

Then, you need to go through the application process. This requires completing several forms, as well as providing supporting documentation and answering any questions the loan officer asks about your business or the purpose of the loan.

These are some of the key criteria lenders use to decide whether to approve you for an acquisition loan:

• Credit: A lender will look at your business credit report (if your business has established credit) and run credit checks for you and any partners who own 20% or more of your company. Minimum credit scores vary by loan type (640 is the minimum for SBA loans).
• Revenue: The lender will examine your company finances to ensure your existing or projected revenue will support the payments required to service the loan. Most lenders look for a debt service coverage ratio of 1.25 times or more (your revenue divided by your debt service must be greater than or equal to 1.25).
• Down payment: Minimum down payments vary by loan type. Most loans start at 10% to 15% of the total transaction, but the payment may be higher based on your credit profile, business cash flow, etc. Some loans, including lines of credit, don't have down payment requirements.
• Use of funds: Lenders will need to know why you are requesting financing (whether you're buying a facility, a company, or a piece of equipment), the value of the asset you want to purchase, how it will impact the profitability of your business, and whether it represents a good business decision.

Not every small business will qualify for a loan to acquire large assets or another company. Some businesses don't have enough revenue to service the loan payments. In other cases, individual business owners may have previous credit problems that need to be cleared up before they can get a loan. If your loan application is denied, you may still be able to finance acquisitions, but you may need to get a co-signer or raise equity capital instead.

What are the advantages of business acquisition loans?

Using an acquisition loan to make large purchases can have a lot of advantages. These can vary based on your business's circumstances, as well as the loan type and the terms offered by a lender.

These are some general advantages of acquisition loans:

• They lower the amount of capital your business must use to complete an acquisition.
• They allow you to make your acquisition and pay it off over time.
• They help you build business credit.
• If used appropriately, they help your business grow its bottom line.
• Loans may be based on your projected revenue (after acquisition) rather than existing sales.

Acquisition loans aren't always ideal. In many cases, businesses may not even qualify to use them. But, for those who qualify and when used correctly, business acquisition loans can be very advantageous in many circumstances.