Buying a Business with an SBA Loan: What Buyers and Sellers Need to Know

from: howtosellmybusiness.com: A Chicago based, Illinois and Midwest Business Intermediary group and M&A information website dedicated to helping lower Middle market and "Main Street" privately held companies improve the value of and assist in - the successful selling of their businesses.

When the financing of an acquisition turns into a discussion - the SBA immediately becomes a topic for both buyer and seller. The SBA Loan programs are a viable method for financing a "Main Street" or lower Middle Market acquisition.

This first article is an attempt to give an overview of the SBA environment and process. That is, what is involved when applying for an SBA loan? How do you qualify? And what does the process look like? It’s time consuming and aggravating (hey, you’re dealing with both the government and a banker… patience required) but, it can be a great benefit for both business buyers and sellers.

The next article from howtosellmybusiness.com, "Important SBA Considerations and Common Questions", will add more depth and context to the SBA process and experience.

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.

When using an SBA 7 (a) loan, a buyer (or combined with seller financing) is only required to put down 10% - 20% of the purchase price at closing. This means a buyer can acquire a business, be paid back on their initial investment (the 10% - 20% down payment) in just a few months, and then be in a position where the business literally pays for itself over the next 10 years.

Plus, because their immediate return on investment is so much stronger, buyers who leverage SBA loans are often able to offer more aggressive pricing, as well as more flexible terms and conditions for the acquisition. 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 because of that limited exposure, they and the SBA, 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 bank/SBA?

Second, the bank will look at the buyer, their personal financial situation, and their qualifications - i.e., the buyer's professional background and skill sets. Even if the business can service the loan, the bank wants to be assured the acquisition 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 reviews is the business’s current earnings. The SBA wants to feel secure that the buyer will be able to comfortably re-pay the loan with the company’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 obtaining the right ratio. This procedure looks similar to what brokers use when we add back various expenses that may exist for the mitigation of a tax burden, adjusting for accounting strategies or for financial benefits that inure exclusively to the owner.

Keep in mind, the SBA will want to acknowledge that the buyer is receiving a salary and can comfortably support their personal financial needs. Therefore, rely on calculating a salary as part of the debt to earnings ratio. If you have additional sources of income (such as a secondary business), this can be included in the debt to earnings ratio as well, which will boost 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 utilizing the SBA for a business acquisition, the buyer's banker will ask for the last 3 years of US-based corporate tax returns. Almost all deals disclose at least 3 years of the acquisition company's tax returns.

That said, the main concern of the SBA is whether the business can service the loan debt. If it is obvious from past returns that servicing the loan will not be an issue, the loan may be based on fewer years of corporate taxes.

Additionally, the business being acquired has to be based in the U.S and have filed U.S. corporate taxes. 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 review and 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 achieve.

The lending bank will examine several 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? (Personal tax returns will be requested.) 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. A personal FICO score below 680 would be problematic as would a business FICO score of below 160.
• 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 very recently assumed a substantial amount of additional debt.
• Buyer's Real Estate Assets – While many SBA loans are extended without real estate security, some banks may nevertheless require it. SBA rules limit banks to only securing the loan against real estate and the company's assets, so the buyer's other assets are usually safe.
• Buyer's Resume – If you are highly qualified (professional history and skill sets) and well suited for your acquisition, this will only help in securing 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 for the acquisition, they have some requirements, for both the buyer and the seller, when it comes to the structure of a deal. Most of these requirements, for both parties, are highly favorable.

Allowable Deal Structures:

•  Full acquisition of business
• Cash (including SBA portion) + Owner Financing
• All Cash (including SBA portion)
• Consulting Agreement (less than one year, limited to no payouts)

Disallowed Deal Structures: 

• Partial buyouts or partial equity buy in
• Earn-outs
• Performance-based financing
• Employment agreements
• Long-term expensive consulting agreement

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 extend less money upfront, the SBA's participation also helps shape the acquisition's structure that incentivizes the buyer to provide a more solid and competitive offer. It is a win-win for both buyer and seller.. and yes, your banker.

Feel confident, that when working with howtosellmybusiness.com Intermediaries and Rex Rossi of Premier Business Group, that we work with the most experienced and effective network of SBA approved lenders in the Mid-West and Chicagoland area.

If you personally, or your company, would like help and/or have any questions on how to sell your business - or the "best practices" necessary to make your business more valuable and salable visit: www.howtosellmybusiness.com.

Or please contact directly:

Rex Rossi

[email protected] | 708.433.9410

Founder and Executive Director - howtosellmybusiness.com 

Senior Intermediary and Business Consultant: Premier Business Group, Inc.

Preeminent M & A Specialist to Privately Held Companies: Manufacturing, Distribution, Service and Agencies in the Chicagoland and Midwest markets.

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