HOW ARE LENDERS DEALING WITH PPP LOANS WHEN UNDERWRITING ACQUISITIONS?
We are already seeing quite a bit of acquisition activity to start 2021, and in most of that activity one consistent issue seems to be rearing its ugly head. That issue is how to handle Paycheck Protection Program ("PPP") income when calculating what a business is worth and how to finance that business. The majority of sellers are including that income in their reported cash flow, either reporting it directly on their income statement or including it in the add-backs to cash flow to justify a list price. However, this is creating two major issues as it relates to financing.
The first issue relates to cash flow. Very few lenders are including PPP funding in their cash flow analysis. Depending on the amount of funding a business received, not including it can mean the difference in making a deal cash flow for a lender or not. The reasons most lenders are not including PPP in cash flow (including many SBA lenders), is because it was a forgivable grant that should not even flow through the income statement, it is deemed to be one-time (although some businesses will get a second grant this year), and inclusion of the grant does not reflect true cash flow going forward. Lenders want to be sure the business's core cash flow can support operations going forward without the grant.
The second issue relates to valuation. Almost all lenders require a business valuation (the SBA always requires the valuation over a certain price point) to confirm the price being paid for a business is reasonable. Most of the valuation firms we have spoken with have stated they are not including PPP funds in their analysis. Since most companies are valued and sold based on a multiple of cash flow, the removal of PPP funds can have a dramatic effect on whether a business will value out or not. Obviously, if a business valuation does not come back as expected, most of the time this will kill a deal for a lender unless the transaction can be renegotiated with the seller.
Now, there are potential ways around this issue. Even though cash flow for the full year in 2020 might be reliant on PPP funds to work and it does not work if those funds are removed, we can always look at the cash flow without PPP on a limited window of time in 2020 to see if we can make it work. Here is how that would work. Say the company was substantially impacted in the second quarter of 2020, and the PPP funds helped them through that quarter. If we can show the cash flow worked for the first, third, and fourth quarters combined or for the last six months combined, without having to rely on the PPP funds, we have been successful in convincing lenders to move forward and finance the transactions based on cash flow over a more limited time period versus all of[redacted]So if it were the last six months that worked and cash flow is now stabilized at or near to normal levels, the lender would use six months of debt service and if their required ratios are hit, in most cases the lenders are approving the transaction and moving forward, even though those ratios were not hit on an annualized basis without PPP. In addition, we have seen valuation firms willing to accepted the same argument in valuing businesses, and we have not had any issues with the business valuations coming back for less when this method has been used. Typically in order for this argument to work the business has to have largely recovered from the initial damage caused by Covid-19 and the last four to six months of revenues have to be back to a level to support the debt and close to a level seen in 2019.
So the main point I want to make is that if a business received PPP funding in 2020, it is going to be hard to get a loan approved and the business valuation completed for the purchase price unless there is sufficient cash flow without those PPP funds to support debt service. However, even if cash flow does not work without PPP, if you can get a profit & loss broken down on a monthly basis for both 2019 and 2020, and we can show stabilized or improving cash flow for the second half of 2020 or non Covid-19 impacted months of 2020 that supports the loan and is comparable to operations for those same months in 2019, then we can still potentially get the deal approved only using cash flow from a partial year in 2020.
My preference is always to address these types of issues on the front end at time of contract, rather than going down the path of spending time and money on approvals and reports that do not end up supporting the transaction. If you are looking at any transactions and need someone to complete a quick cash flow assessment in advance and advise you on how lenders are going to look at the transaction, we are always willing to do so. We do not charge anything to do a quick cash flow assessment up front and we provide you our summary so you can see how lenders are going to view the transaction. You can reach me directly at[redacted]or via email at [redacted]
I suspect most purchases this year are going to be impacted by PPP in one way or another, but that still does not mean the transactions are not financeable. It just might take some creativity in how to present the business to lenders to tell an accurate story of why the cash flow and valuation are still there despite Covid-19 and without PPP included. We have had success using partial year cash flow to get loans approved and closed on multiple business acquisitions and expansions already, and anticipate using this method quite consistently in 2021.