A bank pre-approval or pre-qualification letter is a document issued by a bank or lender that indicates that a borrower has met certain criteria and is eligible for a loan up to a specified amount. It is commonly used in the context of mortgage loans but can also apply to other types of loans. The purpose of a pre-approval letter is to give the borrower an idea of how much they can borrow and to demonstrate to sellers that they are a serious and qualified buyer. It provides a level of confidence for both the borrower and the seller during the home buying process, as it shows that the borrower has undergone a preliminary evaluation by the lender and has been deemed creditworthy.
Small Business Administration (SBA) lenders generally do not provide pre-approval letters in the same way as mortgage lenders. The SBA loan application process involves a more comprehensive evaluation of the borrower’s business and financials. Instead of a pre-approval letter, SBA lenders typically issue a financing “term sheet” to the borrowers after some initial due diligence on the part of the bank. A large majority of business acquisitions issued term sheets make in through underwriting and are financed by an SBA lender assuming neither buyer nor seller walks away from the transaction, so receive an SBA term sheet from a credible SBA bank is an important step in one’s financing journey.
When evaluating potential borrowers for Small Business Administration (SBA) loans, SBA bankers typically consider several key lending criteria to assess the borrower’s creditworthiness and the viability of the business. While specific criteria may vary slightly among lenders, here are the top factors that SBA bankers commonly examine, all of which we ask about with our lender match tool:
Key SBA lending considerations: Business
Business Location: Some SBA lenders only lend in certain geographies.
Use of Proceeds: Banks will want to know how the loan will be used. Real estate and long-term assets are deemed more attractive. Pure working capital loans are not as attractive to most SBA lenders.
SBA Loan Amount: $5,000,000 is the maximum.
Years in business: Businesses greater than two years old are more attractive than startups. To verify profitability, banks will want to review two full years’ federal corporate tax returns.
Business description: Every bank has industries it likes more than others.
Key SBA lending considerations: Borrower
Equity Injection: SBA loans typically require the borrower to have a certain percentage of equity injection or down payment. Bankers evaluate the borrower’s ability to inject personal funds into the business, which demonstrates their commitment and financial stability. No SBA bank will lend 100% for an acquisition. 80% – 90% is more common.
Personal liquidity: Buyers can prepare detailed personal financial statements that outline their assets, liabilities, income, and expenses. This document provides an overview of their financial position and can help establish their ability to finance the transaction. Banks want to know that buyers aren’t using 100% of their personal funds for an acquisition.
Credit Score: SBA bankers review the borrower’s personal and business credit history to assess their repayment track record and overall creditworthiness. A strong credit score and a history of responsible credit management increase the likelihood of loan approval. A minimum credit score of 640 is often needed. A credit score of 700 or better is ideal.
Profitability: SBA bankers analyze the borrower’s Debt Service Coverage Ratio (DSCR), which measures the business’s ability to generate enough cash flow to cover its debt obligations. A higher DSCR indicates a stronger ability to repay the loan. In general, a 1.15 DSCR is a minimum for most SBA lenders. The business must be able to generate enough cash flow to meet the debt payments. Even if there is sufficient collateral, which is not a requirement for an SBA loan, the business must generate cash flows higher than the SBA loan payments. For example, for a ten year, $1M loan at 10.5% interest, the annual SBA loan payment would be $162,000 but the bank will want to see $186K. Also, the bank will want to see $186,000 in annual cash flow assuming a DSCR of 1.15.
Lack of adequate cash flow is the top reason we see SBA loans being denied.
Direct Industry Experience: SBA bankers assess the borrower’s industry experience and the qualifications of the management team. They consider factors such as relevant industry expertise, previous business ownership or management experience, and the capability of the team to successfully operate the business. If the buyer lacks direct experience, “relatable” experience is considered, meaning the buyer has business experience the SBA banker believes will convey well at the new business.
By completing our lender match tool, we can provide banks with a high-level overview of a project to determine their initial interest level. This approach streamlines the process for both SBA lenders and borrowers because borrowers are only talking to banks who have an initial interest. We do not make introductions when there is not a good fit, saving both parties time.
While it’s not a pre-approval letter specific to SBA loans, buyers can obtain a preliminary assessment of SBA financing from our lender network through an initial phone call with bankers and/or an exchange of basic financial data, which may provide comfort to both buyer and seller that SBA financing is plausible given the data provided.
How do I convince a seller I can finance a transaction?
When buyers of businesses are seeking to demonstrate their financial ability to finance a transaction, they can take several steps to provide assurance to the seller. Here are some of the most common aspects to highlight with a business owner in the absence of pre-approval or pre-qualification letters:
Personal Financial Statements
Buyers can prepare detailed personal financial statements that outline their assets, liabilities, income, and expenses. This document provides an overview of their financial position and can help establish their ability to finance the transaction. For SBA loans, SBA Form 413 is used to disclosed personal financial statements.
Proof of Funds
Buyers can provide documentation to demonstrate their available funds for the down payment or acquisition costs. This may include bank statements, investment account statements, or letters from financial institutions verifying the availability of funds.
Resume/Credentials
Buyers can provide their professional resume and highlight their relevant experience, skills, and qualifications. This helps establish their ability to successfully manage and grow the acquired business.
Reference Letters
Buyers can obtain reference letters from previous business partners, lenders, or other professionals who can vouch for their financial stability, business acumen, and ability to manage financial responsibilities.
Previous Fundraising Success
A track record of previous fundraising success is another positive attribute that lenders appreciate. If the buyer has successfully secured funding in the past, it demonstrates their ability to present compelling investment opportunities, build relationships with investors, and manage financial resources effectively. It signifies that the buyer has a proven ability to structure and execute financing deals, which can enhance their credibility in the eyes of lenders. Past fundraising success showcases the buyer’s financial acumen and their capacity to generate investor confidence, making them a more attractive candidate for financing.
Personal Investor Network
Having a robust personal investor network can be advantageous when seeking financing. Buyers who have cultivated relationships with potential investors, such as angel investors, venture capitalists, or high-net-worth individuals, have access to additional funding sources. Lenders appreciate buyers who can tap into their personal investor network as it demonstrates the ability to secure additional capital beyond the loan being sought. It also indicates that the buyer has a strong network and connections within the business and investment community, which can be leveraged to support the acquisition and future growth of the business.
SBA lenders conversations
Identifying potential lenders suitable for financing the acquisition is a proactive approach that lenders appreciate. Buyers who have conducted research and identified specific banks that have experience in providing financing for similar acquisitions show their dedication and preparedness. By understanding the requirements, terms, and preferences of different banks, buyers can tailor their financing proposals accordingly. This attribute demonstrates the buyer’s diligence in finding the right lender and provides confidence to a seller that a third-party lender (or investor) has expressed interest in the deal. It also indicates that the buyer is committed to exploring various financing options and finding the best fit for their acquisition.