Understanding a Business Loan
Owning a business is a challenging but rewarding experience. However, it doesn't help if you can't make payments and purchases on time. Business loans have become a source of vital and immediate cash flow for many business owners. Taking out a business loan will allow you to carry out regular business activities if you are experiencing financial constraints, but it is important to remember that borrowing money has certain conditions that need to be met.
Should You Buy a Business or Start One?
Starting a business from scratch can be a fulfilling pursuit, but multiple short and long-term challenges can influence its success. If you start a business from scratch, you’ll need to establish structures and operations that an existing business already has in place.
One of the most significant benefits of purchasing a business is that the financial groundwork already exists. A current business can easily construct an accurate and timely financial estimate or forecast potential income. Existing businesses also have a cashflow, and a tax return system in place.
Existing companies often have established suppliers and vendors, including a brand and customer base.
Likewise, conducting research on business that may interest you is much easier than conceptualizing an entirely new enterprise. Business buyers can access thousands of businesses for sale at any time. If you are more interested in franchising as a route to business ownership, you can easily browse through exciting franchise opportunities too.
If you are focusing on expanding your portfolio, and you are interested in targets of a higher value, you can explore MergerVault, an exclusive space that lists high value merger and acquisition targets.
Evaluating a Business Before You Apply For a Loan
One of the most important processes you need to undertake before applying for a loan is to value a business, and it requires detailed preparation, analysis, and expert counsel. Evaluating a business to apply for a loan can be a tedious and time-consuming task, so it is important to have a checklist of things to do. Before we dive into some important points about valuation, you can read a more detailed guide on the valuing process here.
Here are some questions you should ask about the business you want to buy:
- What are the areas of expertise?
- What are some areas that can be expanded once it’s purchased?
- Who are the suppliers?
- How many products or services does it sell every year?
- Are there any products or services that sell better or with higher margins than others?
A SWOT analysis is a fantastic starting point to understand the chosen business. This method gives you a very comprehensive picture of the business, as it analyses its weaknesses and strengths.
Some other important areas you should consider are:
Recognize why the business is being sold
There are various reasons why a business owner has decided to sell their business. When evaluating a busines you’re interested in, you show understand why it was sold in the first place.
Potential for expansion
Are you content with the current situation of the business? Is the business as profitable as you'd like it to be? Most people who purchase a business aim to expand it into something bigger, so you should investigate the business's potential to grow. It might not be worth your time and money if these possibilities are constrained.
A business’s location is imperative to its success. Monitor the traffic in the area to see if the location is suitable and sustainable.
Employees who work for a profitable business are usually respectable and committed. As a result, when acquiring a business, you should ensure that the current personnel will be retained.
Many business owners believe that valuing a business is only significant when it is time to sell it. While this is true, it is beneficial to have a sense of the business’s true worth before purchasing one (particularly through a loan). Performing appropriate due diligence before your purchase is crucial, and we recommend understanding the value of your target yourself, before approaching an experienced valuation specialist.
If you have access to financial data, you can use ValueRight to conduct a pragmatic valuation of the business you’re interested in. These insights can be used in your business plan when applying for a loan, and it can also be used to negotiate a better deal with the seller if needed.
Points to Consider Before You Assess Finance Options
When buying a business, the amount of your down payment is essential since it will have a long-term influence on your finances. While there isn't an explicit formula for calculating the "correct" number of down payments, it's paramount to demonstrate that you're willing to put some money down. A decent rule of thumb is that the down payment should cover 20% to 30% of the total buying price.
Costs of interest rates
The financial institution you choose will have set interest rates, which might be variable or fixed. It is important to take into account these interest rates and determine if you will be able to afford them if you take out a loan.
A credit score is crucial if you are applying for a loan – regardless of your objective. The three major credit-reporting bureaus that track your credit score are Experian, Equifax, and TransUnion.
- The information in your credit report is used to determine your credit score
- Credit scores between 660 and 900 are regarded as good, very good, or outstanding
Appropriate debt-to-income ratio
Debt-to-income ratios of 42% or less are considered appropriate amongst Canadian lenders. Of course, the maximum DTI required to qualify for a loan varies depending on the lender and the sort of loan you're seeking.
For example, if you earn $4,000 per month and have debt that includes a $1,000 house payment, a $500 auto loan payment, your debt-to-income ratio will be 37.5%. We divided $1,500 by $4,000 to get that figure.
Cash reserves to pay closing costs
Cash reserves are assets that you can quickly access if you need assistance paying off a loan or mortgage. If you have $7,200 in a savings account after closing on your loan and your monthly loan payment is $1,200, you'll have a six-month reserve. Cash in your bank accounts isn't the only thing that counts as a reserve. Other sorts of assets are also eligible, such as:
- Invested funds in retirement accounts such as an Individual Retirement Account (IRA)
- Stocks, bonds, mutual funds, and money market funds
- Certificates deposit (CDs)
- The monetary worth of an insurance policy
- Trusted funds
In the bank loan application procedure, having a well-researched, compelling, and professional business plan is fundamental. A bank loan’s business plan should concentrate on the numbers, emphasizing scalability and longevity, as the lender's primary worry is your potential to pay the money back.
Improved bank loans negotiation
Finance markets are always expanding, and you should negotiate your loan terms thoroughly. This can lead to:
- Better interest rates and reduce your loan fees
- Negotiate lengthier loan terms and amortization periods
- Negotiate a no-penalty prepayment policy
- Make sure there are no "infinite guarantees" in the contract
- Limitations on collateral should be discussed
Types of Funding to Purchase Your Business
Personal loans, school loans, and most credit cards are examples of unsecured loans, which might be recurring or term loans. Credit cards and personal lines of credit are illustrations of recurring unsecured loans. With an unsecured loan from Fairstone and Loans Canada, you can get the money you need immediately.
A commercial mortgage is comparable to a typical mortgage in that it entails borrowing money to fund a piece of real estate. The mortgage is usually secured for the commercial property, which serves as collateral until the loan is paid off. The borrower then repays the loan in equal monthly payments (plus interest and fees) over a certain period. Various banks like Royal Bank, CIBC Commercial Bank, Bank of Montreal can offer a commercial mortgage.
Asset finance is when a company's borrowing is directly linked to the value of a tangible asset, including real estate, automobiles, or other assets. You make smaller, more frequent payments over a set period.
Fees and interest are levied on top of the asset's cost. Ownership of the asset may be returned to the lender or passed to you after the period.
The Canadian Finance & Leasing Association reports that while asset finance is not popular in the prairies and Atlantic Canada, it is gradually gaining traction. You can find more information on asset-based finance on CFLA.
When a loan is issued based primarily on the value of the assets offered as collateral, this is known as asset-based lending (collateral).
For instance, if a company needs $100,000 immediately but cannot establish its obligation to afford the additional debts through cash flow, it can pledge a specific asset (a piece of real estate, equipment, stock, or bond) to obtain the loan. If monetary repayment is not feasible, pledging involves agreeing to turn over an asset to the lender.
Because highly liquid assets such as Treasury bills, equities, bonds, mutual funds, and exchange-traded funds (ETFs) are easier to convert to cash, lenders like them, high loan-to-value (LTV) ratios, lower interest rates, and more flexible repayment terms are all characteristics of loans backed by highly liquid assets.
You can explore these institutions:
A combination loan comprises two diverse mortgage loans issued to the same borrower by the same lender. When a buyer can't afford a 20% down payment but doesn't want to pay for Private Mortgage Insurance (PMI), it's common to take out this loan. Pivot Financial is one of the leading institutions to avail such loan options in Canada.
Other Sources of Funding Available to You
It's never a good idea to put all your eggs in one basket. This is particularly true when it comes to funding to buy a business.
Broadening your sources of capital will not only help your company survive any downturns but will also increase your chances of acquiring the right financing for your needs. Let’s take a look at some other options.
Angel investors are wealthy individuals or experienced professionals who make investments in small businesses.
They are often industry leaders who provide not only their experience and network of connections but also their technical and management expertise. Angel investors often invest between $25,000 and $100,000 in the early phases of a business. Institutional venture capitalists can offer more significant investments in the $1,000,000 range.
The National Angel Capital Organization (NACO) is a non-profit apex body that assists angel investors in Canada.
Grants are a valuable resource for establishing a business. Small business grants are an excellent way to fund various business components. A grant might be used to fund the exploration of a business possibility, give working funds for a business plan, or help in plenty of other ways. The Canadian Government offers business grants and financing for such requirements.
You can also take a look at our guide on small business grants for different sectors.
Government-guaranteed lending scheme
The Highly Affected Sectors Credit Availability Program (HASCAP) loans program provides guaranteed, low-interest loans ranging from $25,000 to $1 million to small businesses in Canada.
By providing liquidity with lenders, the Canada Small Business Financing Program makes it candid for all types of businesses to obtain loans from financial institutions. During the last decade, over 56,000 loans totaling $10 billion have been made to small businesses.
Family members and friends
Friends and family members, if you're lucky, can be the most understanding investors. They are less likely to require you to put your house up as collateral, or charge you interest rates. However, regardless of the family member or friend, a contract should always be drawn up to mitigate any unforeseen disagreements.
Venture capitalists (VC) offer funding to startups and small businesses with the possibility for long-term expansion. Investors, investment bankers, and other financial institutions are the most prominent examples of venture capitalists. For example, the Business Development Bank of Canada offers multiple venture fund options that you can explore.
Equity financing is the process of raising funds by selling shares of stock to one or more stockholders. This can be an excellent approach for a small business owner to generate money and receive some extra operating capital to help them develop.
When you obtain funds through equity investment and give less than 50% of the company's shares to private investors, you maintain ownership of the firm. As a company grows, it may need successive rounds of equity financing.
Own business funds
Compared to alternative financing choices, funding your own business allows you far more freedom. It also means you won't have to repay or rely on outside investors or lenders, who may choose to stop supporting you at any time. You'll keep complete control of the business. However, it is very rare for a small business owner to have a significant amount of capital saved up.
One of the most prevalent sources of financing for small and medium-sized businesses are bank loans. Most banks in Canada offer loans with different interest rates, so you’ll need to conduct some research on what suits your business needs. However, if you default on your loans, the bank has the right to confiscate your assets to pay off the debt.
Achieving Your Acquisition
Now that you've gained an understanding of different types of loans and lenders, it's time to apply for a business acquisition loan that suits you.
As you move through the underwriting process, make sure you understand lender's requests and always clarify any misunderstandings. You will receive an offer from one or more lenders after you have completed the underwriting procedure. Before accepting any proposal, carefully read the business repayment plan and always ask questions.
Be confident, and we wish you the best on your business buying journey. You can get in touch with us if you have any questions.