Q2 20222 Acquisition loan update: Bankers are still doing SBA acquisition loans, as these loans make up a large percentage of the deals done by most SBA lenders. However, given the anticipated Federal Reserve’s tightening of interest rates beginning soon, bankers are beginning to ask for:
- Slightly higher down payments. Some banks will still do 10% if the owner has industry experience, but many are asking for more down.
- Higher cash flow ratios – Credit teams are modeling in a higher interest rate environment, so cash flow/debt ratios above 1.15 up to 1.3 is becoming more common.
We encourage borrowers to move fast on their M&A deals as the financing environment will likely get worse.
SBA business acquisition loans
We work with many entrepreneurs looking to the SBA’s 7(a) loan program to fund a business acquisition. While much of the eligibility and SBA loan requirements for a business acquisition loan are the same as any SBA 7(a) loan, there are some unique aspects to acquisition loans we want to highlight to help you navigate the exciting mergers and acquisitions (“M&A”) journey.
SBA bank suitability
Many SBA banks will decline acquisition loan opportunities based on a variety of factors, such as geography, industry, buyer’s industry experience, and the size of the loan. Acquisition loans are simply riskier and more time consuming for banks, so it is critical that you find an SBA bank that is a good fit early in the process.
We work with many of the top SBA lenders in America and know the types of acquisition loan opportunities they prefer, so when you connect with SbaLenders.com we will route you to banks who we believe may be a good fit for your business thereby saving you hopefully time. We ask many questions via our Find me a lender tool, which allows us to better match borrowers with interested banks.
Benefits of SBA acquisition loans
- Longer payback periods – 10 years for traditional SBA loans; 25 years for real estate
- No collateral needed
- No loan covenants
Costs of SBA acquisition loans
SBA loans cost more than traditional commercial loans. In general, borrowers can expect top the following costs associated with an SBA loan:
- Interest rate – 5.5% to 7.5% is the current typical range for most SBA loans.
- Guarantee fee – Up to 3.75% of the loan amount. Paid one-time at closing. In addition, there is a .546% guarantee fee paid on an ongoing basis. This fee is being waived during until September 2021 as part of a Covid relief bill.
- Third-party service fees – For an acquisition loan, the SBA must have a business valuation completed. Typically cost around $3,000. In addition, borrowers acquiring real estate must have an environmental study done on the property, and an appraisal of the value of the real estate. These two services will cost around $3,000 each as well.
First-time buyer and first-time seller
Most acquisitions of loans, regardless if they are funded with SBA loans or not, are between a first-time buyer and a first-time seller. As a result, usually there are huge disconnects between buyer and seller expectations regarding valuation, structure, and timing of the transaction. To help you navigate all the nuances of a transactions we recommend that you engage with your accountant, lawyer, and business advisors early in your discussions with the buyer. If you do not have these resources available to you or if your team does not have sufficient M&A experience, look to engage experts who do.
Once the deal has been verbally negotiated, put the key deal terms in writing. Typically, buyers and sellers will sign a nonbinding Letter of Intent (“LOI”) that memorializes the important terms of the transaction. Letters of Intent (aka “Term Sheets” or “Indications of Interest”) are normally only two to six pages. After the LOI is signed, the negotiations on the economics of the deal are largely done and both parties can then focus on the “due diligence” phase, which is where the buyer confirms the information provided to the seller.
After due diligence is substantially complete, the buyer will instruct counsel to begin drafting the actual purchase agreement, which may be a 10 – 50-page agreement. For smaller transactions where a business broker Is involved, the broker may provide the parties with a boilerplate purchase agreement. We still encourage you to engage counsel to review any agreement to protect your interest.
One common misconception amongst first timers is the time it will take to close an acquisition loan. Anticipate two to four months from LOI signing to close if the process goes smoothly. Smaller deals will take less time than larger ($1 million or more) deals.
First-time buyers often believe that SBA banks will fund 100% of the purchase price of their transaction. This is not the case. The SBA requires that a buyer put a minimum 10% of the acquisition of equity (i.e., cash) into the deal. Many SBA banks have internal requirements that require borrowers to put more into the deal – often between 15% – 25%. For a $1 million acquisition, a buyer may be asked to put in $100,000 up to $250,000 into the transaction, and the SBA lender will lend the remainder.
The buyer’s equity injection varies based on a variety of factors, such as the bank’s requirements, the buyer’s industry experience (less experience equates to a higher equity requirement), and the current business and economic trends. For example, due to Covid many lenders are not lending to hotels at all and ones that are have increased the buyer’s equity injection to 25%.
What do you do if the bank is requiring 20% down and you only have 10%? A few options to consider are 1) Seller financing and 2) equity investors. Sellers will sometime take a promissory note for part of the acquisition price. The seller’s note is subordinate to the SBA loan. Back to the example above, for a $1 million acquisition, a bank may be willing to provide a $800,000 loan if you put in $100,000 and the seller takes a note for $100,000. Even with seller financing, the SBA and SBA banks will still require the buyer to put a minimum of 10% into the deal (i.e., cannot finance a purchase with 80% coming from the bank and 20% coming from the seller). The buyer must have skin in the game.
If the seller is unable or unwilling to take a promissory note and the bank is requiring a bigger equity injection than you can provide, consider raising capital from outside investors. For an equity raise under $500,000, friends, family, and local angel investors are often the best bet as they know you or may know about your reputation or the business already. Raising capital from outside investors will dramatically increase the time it takes to close a transaction (plan on two to six months) unless you know the investors very well. Keep in mind that the SBA requires anyone who owns 20% or more of the business will be required to personally guarantee the entire SBA loan.
Another hurdle related to financing is the liquidity of the buyer (i.e., personal stocks, bonds, cash, and retirement funds). SBA banks do not want to see you put your last dollar in to the business you are acquiring. Rather, they want to see that you have personal liquidity after the deal closes of at least 10% of the purchase price. Back to our $1 million purchase price example: if the bank requires $150,000 (15%) from you, they will want to see $250,000 in personal liquidity ($150,000 into the deal plus a minimum $100,000 or more that you have outside the deal).
Between the SBA minimum requirement of 10% into the deal plus 10% outside the deal, a borrower will need to have 20% or more of the purchase price in liquidity when approaching an SBA lender for a loan. This is often a requirement that unfortunately many aspiring buyers are not able to meet.
The financing dance
Sellers want to see that a buyer has the money to close on a transaction before signing an LOI or purchase agreement. Banks want to see that a buyer has an LOI or purchase agreement before engaging. So what is a buyer to do?
Our network of SBA banks fall into two categories – some will talk to borrowers before deal terms are in writing with the hopes that borrowers will return to them once the deal is in writing; others will only engage once at a minimum an LOI is in place. We can route you appropriately to various SBA lenders based on where you are in the process with the seller.
One approach that seems to work well is for a buyer to get the deal under a nonbinding LOI with a term of four to six months and a financing contingency. The only parts of the LOI that are typically binding are 1) confidentiality and 2) a no shop provision (a period of time that prohibits the seller from seeking other offers for the business while you are actively working on due diligence, financing, and closing). We recommend telling the buyer you are seeking a loan for a portion of the purchase price and the deal is contingent on you obtaining adequate financing.
The first impression you make with the seller and potential banks are critical. They will be ascertaining through interactions with you whether you will be able to pull off the transaction. If you cannot then they have wasted time and money. To bolster the bank’s first impression of you, make sure you have reviewed the following information and have these documents at your fingertips on the very first call with the bankers:
- Last 3 years financial statements (balance sheets and income statements)
- Current year-to-date financial statements
- The Company’s last 3 years federal tax returns
- Your personal last 3 years federal tax returns
- Copy of LOI, purchase agreement, and/or key deal terms
- Discussion of the impact Covid has had on the business
- Bios of key management personnel and/or LinkedIn profiles
If numbers and financial statements are not you strong suit, engage someone who is strong in this area who can help. We can tell you the number one request the bankers ask the borrowers to whom we refer them is to see financial data for the past three years. It is critical and if you do not have it, we recommend waiting to approach banks until the financial data has been received and reviewed.
Entrepreneurs looking for an SBA loans frequently tell us “this business has a ton of collateral.” Collateral is nice but is only a secondary consideration for an SBA bank as the bank receives a partial government guarantee for the loan, which provides the bank with collateral. The three most important metrics for SBA lenders are cash flow, cash flow, and cash flow.
Which one of these deals gets done?
Deal A: $1M purchase price for a business with $2M in collateral. Cash flow of $75,000 per year.
Deal B: $1M purchase price for a business with $200,000 in collateral. Cash flow of $175,000 per year.
Most entrepreneurs would say Deal A since the bank can liquidate the collateral if the borrower stops paying on the loan. The correct answer is actually Deal B.
SBA banks want to see cash flow of 15% – 20% of the loan amount to cover the loan payments. Deal B is generating sufficient cash flow to make the loan payments. Deal A is not, and therefore banks would be loathed to make that loan. Banks do not want to make a loan and have to liquidate collateral down the road.
All bankers will look at the “5 Cs” regardless of the use of the loan proceeds (business acquisition, real estate, partner buyout, etc.). The 5 Cs are cash flow (aka capacity), credit, character, condition of the business, and collateral. Let’s take a look of each (in our perceived order of importance):
- Cash flow – No SBA lenders will lend money if they do not think the borrower can repay the principal and interest. Most SBA loans are 10 years or 25 years if a real estate loan. For a 10-year loan, the business needs to generate cash flow (cash revenues less all cash expenses including owners’ salaries and equipment purchases) of at least 15% of the loan amount. For example, a business loan of $1 million would need a business cash flowing at least $150,000 per year to cover the loan payments (in banking parlance “debt service).
- Credit – All SBA banks will run credit checks on all owners who own at least 20% of the business (“significant Owners”). A personal credit score in the mid-600s is the minimum banks will want to see. Anything lower will need a good explanation. High 600s or above is ideal.
- Character – Small business lenders will review any personal or business bankruptcies of all Significant Owners. Some banks vary, but most will want to see no bankruptcies in the past five years. Some SBA banks will go as low as three years if there is a good explanation. In addition, the bankers will review management bios of all 20%+ owners. If the management team has little or no industry experience for the business they are acquiring, banks may require a higher down payment. Per SBA requirements, the minimum cash injection from a buyer is 10%. Entrepreneurs with no industry experience or “relatable” experience may be asked to put 15% to 20% into a transaction.
- Condition of the business – The general trends of the business over the past three years – is the business growing in terms of revenues and cash flow, remaining stable, or shrinking? These are all important consideration for the banks.
- Collateral – Many small businesses have little to no collateral (e.g., real estate or equipment) to back up their loan, which is why the SBA loan program is ideal for many small businesses as banks lend against collateral and not cash flow, which is different from traditional loans. However, all components being equal, banks would rather have loans with collateral than no collateral.