Why Buying a Business with No Money Down Could Be a Bad Idea

Anytime your opening balance sheet is 0% equity to 100% debt, it’s a very high risk for a potential disaster.

 Understanding Over-Leverage

Buying a business with no money down might sound like a dream come true. Here is where every online marketing chimes in about how they can teach you how to do it with ease, of course you’ll have to join their coaching first. However, it often leads to being over-leveraged with debt, which can turn that dream into a financial nightmare. Let's break this down with a detailed example to show why.

The Scenario

Imagine you are buying a business valued at $1 million. You decide to finance this purchase using:

- SBA loan for 80%: $800,000

- Seller financing for 20%: $200,000

Let's go through the details of these loans and how they impact your finances.

SBA Loan Calculation

- Loan amount: $800,000

- Monthly interest rate: 11.5% annually / 12 months = 0.9583% (0.009583)

- Number of payments: 120

Using this formula, the monthly payment for the SBA loan is approximately $11,219.

Seller Financing Calculation

- Loan amount: $200,000

- Monthly interest rate: 8% annually / 12 months = 0.6667% (0.006667)

- Number of payments: 36

Using this formula, the monthly payment for the seller financing is approximately $6,270.

Total Monthly Debt Service

Now, let's add up the monthly payments:

- SBA Loan: $11,219

- Seller Financing: $6,270

Total Monthly Debt Service: $17,489

Annual Debt Service

Annual Debt Service = 17,489 times 12 = 209,868

Profit and Owner's Salary

The business nets $300,000 annually. As the owner, you need to pay yourself $80,000 a year before servicing the debt.

Calculating Remaining Profit After Debt Service

1. Net Income: $300,000

2. Owner's Salary: $80,000

3. Profit Before Debt Service: $300,000 - $80,000 = $220,000

4. Annual Debt Service: $209,868

Remaining Profit: $220,000 - $209,868 = $10,132

Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio (DSCR) is a measure of the cash flow available to pay current debt obligations. It's calculated as:

DSCR = Net Operating Income/Total Debt Service

In this case:

DSCR = 220,000/209,868 or approximately 1.05

A DSCR of 1.05 means you are barely covering your debt payments with very little margin for error. Stated another way, for every $1.05 of net income you have $1.00 of debt that you owe. That’s just plain stupid!  Not to mention no lender would approve this transaction.

Risks of Being Over-Leveraged

1. Lack of Working Capital: With no money down, you start with no buffer. Any unexpected expense can be disastrous.

2. High Monthly Payments: The combined debt payments consume most of your net profit, leaving little room for reinvestment or emergency funds.

3. Cash Flow Issues: A minor dip in business revenue can make it impossible to meet debt obligations, risking default.

4. Stress and Management Pressure: Constantly worrying about making debt payments can distract from focusing on growing the business.

Buying a business with no money down may seem tempting, but the risks often outweigh the benefits. High debt payments can leave you over-leveraged, with minimal profit margins and no safety net. It's crucial to have sufficient working capital and a solid financial plan to ensure the long-term success and stability of the business. Always consider these factors and consult with financial advisors before making such a significant investment decision.

If you are dead set on being one of those who thinks they are the exception to the rule and can make this work, here's my recommendation, find a business that you are passionate about, have direct industry experience, don't mind being a hands on owner operator AND do not pay more than 2x multipe of earnings. The numbers just dont work paying more than this, you'll be over leveraged.