SBA Loans for Buying a Business
If you are considering buying a business using an SBA backed loan, there are two types. The 504 is a collateral based loan commonly used for real estate or equipment. Since most businesses sell with part of the sale price allocated to goodwill, SBA would require the 7(a) structure. The typical 7(a) loan is now based on a 10 year term and does not carry a prepayment penalty. It can be an asset sale structure or 100% stock sale of a privately held company. When real property is sold with the business many times the banks will offer a “blended” term of 20-25 years which is a benefit to the post sale cash flow.
One of the benefits of SBA loans is that they can be used to finance goodwill that isn’t backed by collateral. Banks want to ensure their loan won’t be a complete loss if your business fails, so they prefer for the entire amount of the loan to be backed by as much collateral as possible. Goodwill doesn’t count for collateral, but it can be financed through the 7(a) loan. This makes SBA loans attractive for buying businesses that doesn’t have a lot of hard assets to be used for collateral.
Banks look to the business’s cash flow and credit rating to determine whether the business is financeable. If the business has a track record of sufficient cash to service the debt, the acquisition might be a good candidate for an SBA loan. Typically the banks require a debt service ratio of 1.25 or greater. That means once the buyer has paid their personal and family expenses, there must be enough cash flow from the business to cover 125% of the bank note. Also, since the buyer is important to underwriting the loan, a strong credit score and sufficient industry specific experience are important. Down payment requirements depend on the amount of goodwill on the business. If goodwill is under $500,000 then the buyer’s down payment required is 15%. If goodwill is $500,000 or more then it’s 25%. Generally a seller carry will count towards the down payment requirement.
In many cases, it’s beneficial to keep the seller involved after the sale, either as a minority owner or as an employee. Unfortunately the seller can’t maintain a stake in the business after the sale if the 7(a) loan is used to finance the purchase. This means that the seller can’t keep a minority ownership in the business. SBA also dictates that the buyer can’t employ the seller for more than one year after the sale.
When the seller finances part of the sale with an equity injection required for the buyer’s loan, the seller will be in second position to the bank if the buyer defaults. The SBA requires the buyer to make two years of payments on the bank loan (seasoning) prior to commencing repayment of the seller note. Most SBA backed lenders will consider refinancing the 7(a) after two years of successful payments to take out the seller note.
An earn out is an arrangement whereby the seller receives additional money for the business if the business meets certain financial or operational thresholds during the first year or two after closing. Unfortunately the SBA doesn’t permit earn outs.
In deals that are partially financed by the seller, the buyer may want to negotiate a right to deduct damages (a set off) from principal the buyer owes the seller after closing if the company’s performance is not up to par. The SBA doesn’t allow such deductions, although set offs are permitted if the seller note isn’t considered part of the equity injection (down payment) that is required for the loan.
The SBA requires each person who owns 20% or more of the business to personally guarantee the SBA loan. This means that the buyer can be held liable for the business’s expenses if the business can’t pay its bills. This can be a drawback of SBA financing for people who want to shield personal assets from their business’s liabilities.
For more information, be sure to contact your CPA or attorney for professional advice.