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I used to hate it when a buyer suggested using an SBA loan to acquire one of my client’s businesses. But it is an option more and more buyers are opting to use.
During the Great Recession of 2009, SBA-backed loans were extremely difficult to get as the entire lending industry re-evaluated how loans were being written. But today, SBA lending is alive and robust.
My opinion used to be that SBA loans were slow and uncertain. They seemed to be the choice of buyers who really had no other choice. But I was wrong, and I am happy to admit that! SBA loans are a GREAT option for both buyers and sellers of Internet-based businesses.
For buyers, the benefits are staggering.
Using an SBA loan, a buyer needs to only put down 10% of the purchase price at closing. This means a buyer can acquire an online business, be paid back on their initial investment 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 better deals (and have a better chance of winning those deals) because their immediate return on investment is so much stronger. This is obviously a benefit for the seller as well.
For a seller, they will receive all or most of their funds at closing .
So what is involved when applying for an SBA loan? How do you qualify? What does the process look like? I reached out to one of our recommended lenders at a major bank to ask him every question I could think of about SBA loans, as well as relying on our extensive experience at Quiet Light Brokerage.
The Three Basic Requirements For an SBA Loan
There are a lot of individual boxes your bank and the SBA will require you to check before getting an SBA loan. But at the broadest level, an SBA loan has just 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 you, your personal financial situation, and your qualifications. Even if the business can service the loan, the bank will want to make sure it can do this under your ownership.
Finally, what sort of deal are you, the buyer, making with the seller of the business? The structure of your deal needs to meet certain requirements.
Let’s examine each of these three broader categories in more detail
Can The Business Pay Back The Loan?
For the online business being acquired, the most important metric the SBA looks at is the business’s current earnings. The SBA wants to make sure you will be able to comfortably 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 (it was 1.35:1 when we originally published this blog post in 2015).
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.
Keep in mind the SBA will want to make sure you are getting paid and can support your financial needs. Therefore, count on calculating your salary as a 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.
3 Years Of Tax Returns Is Ideal, But You Might Qualify With Fewer Years
When you first explore an SBA loan for an acquisition, your banker will ask you for the last 3 years of US-based tax returns. In our experience at Quiet Light Brokerage, all of our deals have had 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 it 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.
During the loan process, your SBA bank will hire an independent valuation company to value the business you want to acquire. While there are different ways to value a company, most independent valuation companies will use 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.
For example, if you offered $1,000,000 for a business, but the professional valuation comes in at just $900,000, the SBA will extend a note for $675,000 (75% of the $900,000).
Those of you who are quick at math may notice that I already said a buyer puts in 10%, and with the SBA giving 75% that leaves 15% left for the seller to finance on their own. I’ll explain deal structure later in this post (and why you, as a buyer, might want to do more than 10% at close).
What Does The Business Look Like Under Your Ownership?
While the business being acquired needs to meet certain debt to earnings ratios, you, as the buyer, have an impact on that ratio. Depending on your financial picture, you can make that ratio easier or more difficult to hit.
Your lending bank will examine a few key questions before agreeing to offer a loan:
- Your 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?
- Your 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?
- Your 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.
- Your Equity Injection – I’ll look at down-payment requirements later, but you’ll need to have at least 10% 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 you qualify financially for a SBA loan, a bank may still turn down your loan if you recently took on a lot of other debt.
- Your 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 your other assets are safe.
- Your 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, you can easily run your personal financial situation by a lender to see if your situation will be an issue (much more on this later).
SBA Deal Structures: Four Deal Structure Limitations
Since the SBA is guaranteeing the loan for you 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.
The SBA Will Lend Up to 75-80% of The Purchase Price
For deals less than $500,000, the SBA will guarantee up to 80% of the purchase price of the acquisition. For deals more than $500,000, the SBA will guarantee up to 75% of the purchase price.
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The remainder of the purchase price is the responsibility of the buyer and seller. This is often made up of a combination of seller financing and cash from the buyer.
The Buyer Is Responsible For At Least 10%
For the part of the loan that the bank will not cover, a buyer and seller may negotiate how that part of the purchase price is covered.
From the SBA’s perspective, they require the buyer commit to a minimum of 10% of the purchase price. So, for an acquisition where the purchase price is $500,000, the SBA only requires the buyer to place $50,000 as a down-payment.
A buyer does not have to limit their down-payment to 10%, though. You may decide to put in 20%, 25%, or as much as you can afford.
Any amount not covered by the SBA or by your down-payment has to be covered by seller financing. Lenders tend to prefer deals where there is seller financing as they believe a seller will be more motivated to provide an orderly transition if they have a financial stake in the future performance of the company.
That said, many sellers are reluctant to agree to seller financing.
Seller Financing Is Put On a 2-Year Standby
With an SBA deal, any seller financing is put on a minimum 2-year standby. This means for the first 24 months after the acquisition, the seller does not receive any payments on their portion of the loan.
Of course, most sellers are extremely reluctant to agree to these terms.
Therefore, most buyers try to cover as much of the purchase price as possible which is not covered by the SBA loan. Since this usually amounts to no more than 20-25%, you are still receiving payback on your down-payment within the first year of your acquisition.
Deal Structure No-No’s: Earn-Outs, Employment Contracts, Consulting Agreements, and Partial Buyouts
SBA deal structures tend to be pretty simple to understand as they are made up of just three parts: the bank loan, the buyer injection, and the seller financing.
Some buyers and sellers may want to delve into more complex deal structures, but this should be done cautiously.
In an SBA deal, the seller is not allowed to be an owner, officer, or employee of the company after selling it. This rules out employment contracts or partial buy-outs.
In addition, while the SBA expects there to be a consulting agreement to help with transition services, consulting agreements with heavy minimum payouts or performance bonuses can have a negative impact on first year cash flows. As a result, these are also generally not allowed. Earn-outs are also not allowed for the same reason.
If you are using an SBA loan to acquire an online business, keep your deal structure as simple as possible.Click to tweet
Securing The Loan – What Assets Will The Bank Require?
For the bank, SBA loans are obviously guaranteed by the U.S. Government. For an online business acquisition, this is a very good thing as online businesses are usually “hard-asset poor” and difficult to collateralize for banks.
The SBA gives banks the needed security to extend loans on “goodwill”, but even with this security, banks will not extend loans haphazardly. If a bank has a high default rate, it can affect their ability to extend new SBA loans.
The SBA Will Take a First Lien Position On All Business Assets
In a SBA loan, the bank and the SBA will take a first lien position on all the business assets. What this means is if the business were to go into receivership, the SBA would have the right to liquidate and collect payments first from any assets being sold.
After business assets, the SBA may move onto personal real estate assets with at least 25% equity, then any business real estate. Many banks, however, will extend SBA loans without real estate security.
Finally, expect your lender to require Key Person Life Insurance. This policy protects the bank and the SBA in the event of your death. When applying for an SBA loan, get your life insurance screening done early as this can take a few weeks to process.
One piece of good news is that “other personal assets” outside of real estate are no longer allowed to be considered by the SBA for debt repayment purposes.
Working With a Preferred Lender vs. Standard Processing Lender
There are two types of lenders who participate in SBA lending – preferred lenders and standard processing lenders.
The major difference between the two is found in the underwriting process. When you work with a preferred lender, the bank can manage the underwriting process without submitting your paperwork to a regional SBA office for review.
For a standard processing lender, your loan request needs to be reviewed by a regional SBA office.
Working with a preferred lender is usually significantly faster. That said, even if your bank is a preferred lender, they may choose to send your loan through standard processing if there is any uncertainty on the loan.
So just because you are working with a preferred lender, you may still find yourself waiting as the loan is reviewed by a regional SBA office.
Most SBA Loans Are Completed In 45-120 Days
SBA lenders will often tell you they can complete your loan in 30 days or less. While this may be possible, it is our experience that you should count on a significantly longer process.
The SBA process involves a number of people who need to look at and review different parts of your application. Due to this, occasional delays are almost always unavoidable.
Documents You’ll Need Or Want To Speed Up Your Loan Application
The main complaint about SBA loans is the amount of time it takes to process the loans and the tedious nature of those loans.
As mentioned above, the SBA process involves a number of people who will look at different parts of your loan application. Each person has different items they need to examine and therefore each person will need different documents from you.
You can speed up your loan process by having your documentation prepared and ready to submit. The main documents you’ll want to have prepared are:
- Personal Financial Statement – all SBA lenders require a fully completed personal financial statement.
- 3 Years Personal Tax Returns – these will be used to validate your financial records.
- 4506-T Form – this is used to validate the accuracy and the filing of your provided tax returns.
- Loan Application Form – this will be bank specific, but since the loan comes from the bank (the SBA only guarantees it), they will likely have a loan application for you to complete.
- Borrower Information Form – this is for SBA purposes and helps them track who is borrowing and how much. This is for statistical purposes.
- Pro-Forma Financial Reports – the bank will want to see your projections for the company you are acquiring.
Some documents they may request are:
- A business Plan – this seems to be a very common request among banks as it helps them know you have thought your acquisition through (and if you haven’t, it will force you to put some thought into it).
- Your Resume – this helps the bank get an overall picture of your personal qualifications for this business.
- Profit & Loss Statements For Your Businesses – if you have other businesses, and these are funding your acquisition in any way, you’ll need to provide P&L statements for those businesses.
- Balance Sheets – again, this only applies if you are using an existing business to fund your portion of the acquisition, or if you are using a business to demonstrate stronger debt to equity ratios. If you are, you’ll need to provide your balance sheets.
- Miscellaneous Forms – your bank may have additional forms for you to sign either due to their internal practices, or because of your specific type of deal.
Your seller also needs to be organized throughout the process to keep things moving along quickly. Here are some things your seller should be prepared to create and submit:
- 3 Years US-Based Tax Returns – if your seller has not yet filed for the current tax year, be sure this is done before you go through the process as it can take some time to validate a return which has been filed.
- 4506-T Form – the bank will need to see more than just the tax return. They’ll want confirmation from the IRS that the return was filed, paid, and is in good standing.
- 3 Years Of P&L Statements – these should be accurate and kept up to date. The bank may request new P&L statements from time to time. Make sure your seller is aware these need to be completed monthly in a timely manner. If your seller runs more than one business through the same parent company, you’ll need to send P&L statements for all the businesses they run. The bank will need to verify all the numbers match the tax returns exactly.
- A Balance Sheet – this should be current at the time of submitting the loan.
Is Using an SBA Loan Worth It?
Buyers who have been through the SBA process often have similar feedback: it is hard work, takes a bit longer than they expected, but completely worth the headaches. Not only do SBA loans allow you to leverage your purchase price to put less money upfront, they also provide the seller with a solid and competitive offer.
What has your experience with SBA loans been? Would you recommend the process to a buyer who is considering an acquisition?
Leave your thoughts or questions in the comments below.
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