During the destructive and disruptive Recession of 2009, SBA-backed loans were extremely difficult to find – as the entire lending industry paused and re-evaluated how loans were being originated. Back then, seller financing was the principal method of completing an acquisition. In fact, most banks did not participate in SBA programs or were just not interested or active in financing acquisitions. But today, SBA lending is alive and very robust. Although slow to materialize and complete, SBA Loans and participating Banks are propelling the M&A activity for small and lower middle market business transactions.
The SBA Loan Program: Overview
For buyers, the benefits are incomparable.
Using an SBA loan, a buyer needs to only put down 10% – 15% of the purchase price at closing. This means a buyer can acquire a business, be paid back on their initial investment (the 10% – 15% down payment) in just a few months, and then have the business literally pay for itself over the next 10 years.
Plus, buyers who use SBA loans are often able to offer more aggressive pricing, and more flexible terms and conditions for the acquisition because their immediate return on investment is so much stronger. This is obviously a benefit for the seller.
For sellers, the impactfull benefit is that they will receive all or most of their funds at closing.
And for a banker, the loan is being substantially guaranteed by the Federal Government, and with that, they principally care about three things, …
Can the buyer pay off the loan with the existing business cash flow? Is there some form of collateralization to “latch” on to? Will the business be able to sustain itself for the duration of the loan?
What Is Involved When Applying for An SBA Loan?
From a “real world” perspective, an SBA loan has three basic requirements.
First, is the business being acquired able to sufficiently service the loan? In other words, will you be generating enough revenue to pay back the SBA?
Second, the bank will look at the buyer, their personal financial situation, and their qualifications – i.e., their professional background and skill sets. Even if the business can service the loan, the bank wants to be assured it can be accomplished under this buyer’s ownership and management.
Third, what sort of deal is the buyer executing with the seller of the business? The “structure” of the deal needs to meet certain requirements.
Let’s examine each of these three broader categories in more detail
1. Can the Business Pay Back the Loan?
For the business being acquired, the most important metric the SBA looks at is the business’s current earnings. The SBA wants to make sure the buyer will be able to comfortably re-pay the loan with the business’s current earnings. Like many loans, this is determined by analyzing a debt to earnings ratio.
Currently, the SBA wants to see a debt to earnings ratio of 1.25:1 or better. In other words, for each dollar in loan payments, the business needs to make $1.25 in earnings. This ratio does change from time to time. Not long ago it was 1.35:1. Banks have some flexibility with terms, and with situations, but the 1.25:1 – is typically required.
Calculating the actual earnings of a business is, of course, crucial to getting to the right ratio. This process looks similar to what brokers use when we add back various expenses that may exist for the purposes of reducing a tax burden or for accounting purposes or financial benefits that inure exclusively to the owner.
Keep in mind, the SBA will want to make sure that the buyer is receiving a salary and can support their personal financial needs. Therefore, count on calculating a salary as part of the debt to earnings ratio. If you have other sources of income (such as a secondary business), this can be included in the debt to earnings ratio which boosts your buying power.
2. Evaluating a Buyer’s Financial and Personal Qualifications: What Will the Bank Look At?
Tax Returns: When a buyer first explores an SBA loan for a business acquisition, the buyer’s banker will ask for the last 3 years of US-based corporate tax returns, almost all deals have at least 3 years of tax returns.
That said, the main concern of the SBA is whether the business can service the loan debt. If it is obvious the loan can be based on fewer years of tax returns, you’ll still be able to get approved.
This, of course, means the business being acquired has to be based in the U.S and have filed tax returns. Tax returns from other countries do not qualify.
A Business Valuation: During the loan process, the buyer’s SBA bank will hire an independent valuation company to value the acquisition. While there are different ways to value a company, most independent valuation companies will utilize an earnings multiplier approach similar to what most brokerage firms use.
If your business valuation comes in lower than what you offered for the business, your bank will make their loan based on the valuation, not the offered price.
For example, if you offered $1,000,000 for a business, but the professional valuation comes in at just $900,000, the SBA will only extend a note for $675,000 (75% of the $900,000). Even if both buyer and seller agree to the $1,000,000 transaction price.
Evaluating the Buyer as Owner, Manager and Financing Partner: While the business being acquired needs to meet certain debt to earnings ratios, the buyer also has an impact on that ratio. Depending on the buyer’s financial picture, he can make that ratio easier or more difficult to hit.
The lending bank will examine a few key areas before agreeing to offer the buyer an acquisition loan:
- Buyer’s Finances – What is your financial picture? Is your debt to income ratio outside of what the SBA requires? What does your debt to income ratio look like if you acquire this business?
- Buyer’s Income – Do you have enough money to support yourself and your family? If you acquire this business, will it need to pay your salary? If so, how do the debt to income ratios change?
- Buyer’s Credit Rating – It’s a loan, of course they will look at your credit rating. The higher the score, the better. Below 640 would be a problem.
- Buyer’s Equity Injection – A buyer needs to financially participate with at least a 10% to 20% equity injection of the purchase price. Be sure these funds are sitting in an account (any account – IRA, stock, savings, etc.) at least 2 months prior to the closing date.
- Recent Debt – Even if a buyer qualifies financially for an SBA loan, a bank may still turn down the loan if the buyer recently took on a lot of other, additional debt.
- Buyer’s Real Estate Assets – while many SBA loans are extended without a real estate security, some banks may nevertheless require it. SBA rules limit banks to only securing the loan against real estate, so the buyer’s other assets are safe.
- Buyer’s Resume – if you are highly qualified and well suited for your acquisition, this will help you secure a loan.
While all of this might sound intimidating, a buyer can easily, before submission, run their personal financial situation by a lender to see if their position will be an issue.
3. SBA Deal Structures:
Since the SBA is guaranteeing the loan to buy a business, they have some requirements for both the buyer and the seller when it comes to the structure of your deal. For both the buyer and seller, most of these requirements are highly favorable.
Allowable Deal Structures:
- Full acquisition of business
- Cash (including SBA portion) + Owner Financing
- All Cash (including SBA portion)
- Consulting Agreement
Disallowed Deal Structures:
- Partial buyouts or partial equity buy in
- Performance-based financing
- Employment agreements
- Long-term expensive consulting agreement
This is the first article on the SBA Loan Process, the following article, “Important SBA Considerations and Common Questions”, will add more context and explanation to the SBA process and experience.
Is Using an SBA Loan Worth It?
Buyers experiencing the SBA process often offer similar feedback: it’s hard work, complicated and takes a bit longer than they expected, but completely worth any aggravation. Not only do SBA loans allow a buyer to leverage the deals purchase price and put less money upfront, they also help shape the acquisition’s deal structure which incentivizes the seller with a more solid and competitive offer.