Fundamentals of SBA Debt Financing for Business Acquisitions

In this thread, I will cover some of the fundamental requirements and SBA guidelines for business acquisitions Please feel welcome to read on if you are a searcher or business buyer that anticipates using SBA financing for a business purchase Note: For the purpose of this post and brevity, it is going to be focused on requirements for SBA 7(a) loans over $500K since that is the threshold at which requirements changes, and the deals that Pioneer Capital Advisory LLC helps clients with fall above this size range.

I. Introduction / Background:

The SBA 7(a) loan program through the United States Small Business Administration provides business buyers with a loan program to obtain access to capital that they wouldn't have otherwise been able to obtain through traditional (non-SBA banks) for a variety of reasons ranging from:

1. Lack of collateral: Substantial difference between the loan amount & the value of the assets backing the loan

2. Lower down payment %: SBA 7(a) loans for business acquisitions typically only require a 10% down payment (also called an equity injection) which is proportional to the total uses of funds. Non-SBA (traditional lenders) typically require higher than this

3. Lack of Experience: Non-SBA (traditional lenders) are very fickle typically about a buyer's experience in the industry that they're acquiring in due to the fact that the government is not backstopping the loan. SBA lenders allow first time buyers without industry experience to acquire businesses in industries that they otherwise wouldn't have the ability to While there are other reasons that business buyers who obtain SBA financing don't qualify for obtaining non-SBA financing, the above 3 factors are ones that I see routinely

II. Collateral & SBA 7(a) loans:

The SBA has some very specific requirements when it comes to the collateral required for a business purchase.

Below are some specific requirements to be cognizant of as a business buyer:

1. Personal Guarantees: Anyone in the business buyer group that on a beneficial ownership level owns 20% or more of the applicant business is required to provide a personal guarantee. This same requirement applies if there is an entity buyer at that ownership threshold -- in which case a corporate guaranty would be required. I often get asked the question is there a workaround for this -- if every person owns less than 20%, goes no one have to personally guarantee the SBA loan. The answer is "No."

2. Business Collateral: The SBA requires a 1st GBSA / UCC-1 state filing on the borrower's business entity securing everything ranging from accounts receivable to inventory. All of the business assets of the applicant entity are collateralized with the SBA loan. This also applies if you are acquiring business vehicles or similar. The SBA lender is required to perfect liens on any vehicles or acquired equipment that is financed with SBA loan funds

3. Life Insurance Collateral: While SBA does not impose a specific requirement for life insurance policies for SBA 7(a) loans, Pioneer Capital Advisory LLC has generally observed that most SBA lenders require term life insurance policies in the amount of the SBA 7(a) loan

4. Liens on properties: The SBA requires banks to take liens on properties when the equity in them is 25% or more and when the assets that are collateralizing (backing) the SBA loan do not match the loan amount after applying the discount rate (liquidation rate) to the specific assets. The vast majority of SBA 7(a) loans are not fully collateralized, so this calculation typically comes into consideration by the SBA 7(a) lender. The calculation is done by taking the fair market value of the property or properties owned by those in the buyer group that will be guaranteeing the loan and subtracting the outstanding mortgage amount and also subtracting the maximum amount that could be drawn on any lines of credit that are in place on the properties

Example:

Jane owns a $1 million house She has a $600K mortgage She also has a HELOC with a maximum amount of $120K Jane's equity in the property would be calculated as follows:

Market value: $1 million

(-) $600,000 (mortgage)

(-) $120,000 (HELOC) = $280,000 of equity $280K of equity / $1 million = 0.28 x 100 = 28% equity

If the assets of the business that Jane is buying are less than the SBA 7(a) loan amount, under the above-described situation, she would have to personally guaranty the SBA loan.

III. Debt Service Coverage:

1. The SBA requires debt service coverage of 1.15 or higher. What this means is that there is 15% cash flow over and above SBA loan payments + seller note payments

2. Based on the SBA's guidelines, this debt service coverage ratio can either be historical or projected. Most banks only take historical debt service coverage into consideration. Generally speaking, Pioneer Capital Advisory LLC has observed that 1.25 is the minimum debt service coverage that most banks are requiring to approve deals.

3. Debt service coverage is the single most important factor in the SBA loan approval process. Banks look at what the debt coverage would have been on a historical basis had the seller been running the business with the same debt structure that you as the buyer are taking out for the acquisition.

IV. Equity Injection (Down Payment):

1. The SBA requires that as a business buyer, you have 10% equity based on the total uses of funds

2. What does this mean? Between a combination of buyer cash, seller financing on partial (2 year standby) and full standby, you need to come up with 10% proportional to the purchase price of the business + everything else (working capital/cash to the balance sheet, closing costs, the SBA guaranty fee, your M&A attorney fee, and financial due diligence costs)

3. While the SBA does not mandate a minimum amount of buyer cash, most bank and non-bank SBA lenders require that the buyer group collectively (buyer/operate + investors) contribute half of the 10% down as cash into the deal, with the other half coming from the partial standby or full standby seller's note

4. For anyone that is contributing funds towards the down payment, the SBA requires documentation (bank statements and other related paperwork) to show where the funds are coming from for the down payment to show that there isn't any money laundering taking place as part of the deal process

V. Closing Comments and Thoughts:

This post will be continue at a later point in time, but if you have any questions on it, please feel welcome to drop a comment or send me an email to [email protected]

Pioneer Capital Advisory LLC is solely focused on helping business buyers with obtaining SBA financing for business acquisitions Our primary focus is business buyers that are seeking at least $1 million of SBA 7(a) financing, but more recently on a select basis, we have been taking on engagements for business buyers that are seeking at least $500K of SBA 7(a) financing