The Business Purchase - A Primer for Closing an SBA 7(a) loan for a Business Purchase

Business ownership is at the heart of the American Dream. One of the ways in which many business owners accomplish the goal of owning a business is through an acquisition.

In this article, I will discuss from an SBA closing standpoint, some of the important aspects that go into closing an SBA loan for a business acquisition.

The desired outcome of this article is to help prepare small business owners prepare for the financing an acquisition through SBA by having a high level understanding of some of the granular components that go into the closing process of an SBA 7(a) loan for an acquisition.

"Failing to prepare is preparing to fail" - Benjamin Franklin

One of the key things that goes into a successful business purchase is preparation. In the same way that an athlete practices before a competition to succeed, by preparing for an acquisition in advice, and being ready for what goes into the closing process for bank financing, a business owner will have the best likelihood at a successful closing for an acquisition:

I. Corporate Documentation:

For every SBA loan, a bank is required to obtain a copy of the following items. There is some variance depending on the complication of the corporate structure, but the below documents are typically the primary ones:

Limited Liability Companies:

• Filed copy of Articles of Organization
• Operating Agreement & any amendments or modifications, as applicable
• IRS Tax ID Letter

Corporations:

• Filed copy of Articles of Incorporation (with amendments, as applicable)
• Corporate By-Laws & any amendments or modifications, as applicable
• IRS Tax ID Letter

II. Standard SBA Forms:

There are two SBA forms that are frequently involved in the closing process. The first one is always needed, and the second one comes into play from time to time:

1. SBA 7(A) Borrower Information Form: Since the success of the small business and the likelihood of the repayment of a small business loan, hinges on the owner of the business and the key employees involved with the business, the SBA requires each person that falls into the below categories to complete a form disclosing their personal information:

• For a sole proprietorship, the sole proprietor
• For a partnership, all general partners, and all limited partners owning 20% or more of the equity of the firm; or any partner that is involved in management of the applicant business;
• For a corporation, all owners of 20% or more of the corporation, and each officer and director
• For limited liability companies, all members owning 20% or more of the company, each officer, director, and managing member
• Any person hired by the Applicant to manage day-to-day operations of the Applicant business ("key employee")
• Any Trustor (if the Applicant is owned by a trust)
• Each entity owning an equity interest in the Applicant.?

While banks do have discretion on which employees fall into the "key employee"category it is important to diligence any employees that a buyer intends to keep on as part of the management team or in key roles prior to engaging bank financing. When an individual, such as either an owner or person falling into one of the above categories, does not have a clean background, it adds additional complications that more then not require clearance from either the bank, SBA or both.

2. SBA Form 159: Fee Disclosure & Compensation Agreement

One of SBA's key goals with the SBA 7(a) loan program is to make small business loans affordable to small business owners, one of the documents that comes into the picture frequently is the SBA Form 159.

This form itemizes fees that are involved in the origination process of a SBA 7(a) loan. For example, if the borrower is paying a fee to the bank in connection with providing packaging services, the amount of this fee would be disclosed on this form in the column for amount paid by applicant across from the row labeled "Loan Packaging" in the "Type of Service" column.

As a small business borrower, one important thing to know with respect to where this form comes into the picture. If you are working with a consultant on the loan and are paying them, they cannot also be paid by the bank. This is because SBA wants to help with keeping the program affordable and cost effective both for you and for the bank.

III. Tax Transcripts and IRS Form 4506-C:

One of SBA's program requirements is that a bank or lender is required to match up the numbers that were provided for underwriting and loan approval by obtaining a copy of the tax transcript that was filed to the Internal Revenue Service (IRS). The purpose of this is to protect both yourself as the purchaser of the business, as well as the bank, to avoid potential fraud with false numbers. For example, if the seller provided fraudulent tax returns to you as part of the due diligence process, with numbers showing a higher profit margin than the numbers filed to the IRS, this would get caught when the tax transcripts are obtained by the bank since the numbers would not match up. A way to think of this is as enhanced due diligence. It is something that SBA adds into the program requirements to protect you from buying a business that might not be as profitable as advertised.

During the Letter of Intent process while having the negotiations with the seller, if you know that you will be obtaining SBA financing, having a high level discussion with the seller mentioning that this document will come into play is suggested, to avoid any potential push back with obtaining a signature after the loan has been approved, during the closing process.

IV. Business Valuation:

"Price is what you pay, Value is what you get." - Warren Buffett

The business valuation is one of the most critical parts of the closing process for a business acquisition under the SBA 7(a) loan program. Depending the bank, the business valuation might be ordered prior to the loan approval.

SBA's requirement is that the amount of the loan allocated towards the purchase price cannot exceed the final value of the business that is reported on the business valuation.

In past experience as a closer, I have seen valuations come in across the board falling into three categories - (1) valuations that are on par with the purchase price and allow for the deal to move forward under the current structure; (2) valuations that come in higher than needed, which allow for the deal to move forward under the approved structure; and (3) valuations that come in lower than needed, requiring a modification to the approved structure. In scenario 3, the nightmare scenario, which the bank, borrower, and seller all hope to avoid, what I have seen in the past is typically one of the three following things often in this order:

(1) the seller is asked to carry a seller note or increase the amount of the seller note already in the approved financing structure by the shortfall of the business valuation

(2) the borrower is asked to increase the amount of the equity injection to cover the difference of the shortfall of the business valuation

(3) the borrower asks the seller to reduce the purchase price to fall in line with the business valuation, and the loan approval / loan budget is updated accordingly

I have typically seen scenarios (1) and (2) in prior experience. Scenario (3) sometimes can occur, but is infrequent from my experience as a closer.

V. Equity Injection Documentation:

One of the components of an SBA loan budget for a business purchase is an equity injection. This phrase equity injection means the required amount that a small business owner needs to put towards the purchase of a business. In the most recent issuance of SBA's guidelines, SOP 50 10 6 (Page 251), SBA requires that a business owner contribute 10% of the project cost as an equity injection into the loan.

It should be noted - but for the purposes of brevity, I won't cover in this article - of the 10% equity injection requirement, 5% can come in the form of a seller note, so long as it is on full standby for the duration of the SBA loan.

The Granular Details:

For every dollar going into the project, SBA wants to see where that dollar was two months ago. For this article, the example I will use is an equity injection requirement of $100,000 with a borrower who has paid $10,000 to an escrow agent at the time of signing a letter of intent to be held in escrow until closing.

For hypothetical example, we are going to go with a circumstance in which the $10,000 was paid on 5/11/2021 with a closing date of 6/25/2021.

For the $10,000 that was paid to the escrow agent on 5/11/2021, the SBA will require that the borrower provides the following documentation if payment is made with a check:

1. Cleared copy (front & back) of the check from the bank account that the earnest money check was paid from to the escrow agent
2. April and May 2021 statements to evidence availability of the funds used towards the equity injection
3. Confirmation from the escrow agent that the funds have been received & will be applied towards the purchase price at the time of closing

For the remaining $90,000 of the $100,000 equity injection requirement, assuming a closing date of 6/25/2021, the borrower would be required to provide the bank with the following documentation, with the underlying assumption that the remaining portion of the equity injection was made with a check:

1. May 2021 bank statement from the account contributing the $90,000 towards the equity injection.
2. June interim account printout (pre-closing) showing the account activity of the account that funds originated from including the transaction history identifying the funds coming out of the account. The best practice post-closing is to also obtain the full June 2021 account statement since it provides more holistic information than an interim statement.
3. A copy of the cleared check for the remaining $90,000 being contributed towards the project for the equity injection.

I hope for those of you that are small business owners either with experience using SBA financing for a business purchase, or those considering it for a future financing opportunity that you found some points of this article helpful or insightful. I would love to hear from you with any comments on the content of this article that I could help with clarifying or expanding.

Please note: The opinions and content in this article are my own, and do not necessarily reflect those of my employer. Any SBA loan is subject to bank approval.

#banking #closing #sba #smallbusiness #acquisitions #entrepreneurs