In a situation where one is on the verge of acquiring a small business and has secured SBA financing, is it require that everyone who held any percentage of ownership in the business must exit?
I am hearing about an SBA stipulation that former owners must exit the business but can continue to consult... But that seems counter productive if a seller can continue to add great value and continuity in their employee benefits is a carrot that would convince them to remain and stay productive.
Can anyone provide clarity on this?
Is it a hard SBA loan requirement for seller to exit the acquired business
by a searcher from University of California, Los Angeles - UCLA Anderson School of Management
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What the Buyer and Seller Need to Know
Why Use an SBA loan to Finance a Business Acquisition?
• SBA loans are the most common type of financing used by individuals looking to purchase an existing business.
• The SBA does not lend money; rather, they guaranty a percentage of the bank’s loan, which is typically a 75% guaranty.
• Unlike a non-SBA loan, the SBA guaranty of 75% allows the bank to mitigate the two biggest risks associated with these types of transactions: lack of collateral and change of ownership.
• With an SBA loan, the borrower receives longer repayment terms and a lower down payment.
• SBA loans are one of the best options for almost any business size — from a $100K coffee shop to a $10M manufacturing company (maximum SBA loan size is $5M).
Business Acquisition Lending via SBA: Eligibility Rules
• There must be a 100% change of ownership after the business is purchased. The seller cannot retain any ownership.
• The seller can stay on as an independent consultant for up to 12 months. After the 12 months, the seller must be removed from the business. The seller cannot be an employee of the business after the acquisition.
• The acquisition cannot be structured with an earn out component. The seller can either take a promissory note back in a subordinate position to the bank or have up to a 12-month independent contractor agreement with the buyer.
Structure Rules
• The buyer must put at least 10% down towards the purchase price or appraised value of the business, whichever is less.
• Many times the bank will ask for a larger down payment beyond 10% so as not to overleverage the balance sheet of the business.
• The 10% down payment can come from two sources:
• Liquid, un-borrowed funds from the buyer (i.e. cash, marketable securities);
• A combination of cash from the buyer and up to 5% of the purchase price on a standby seller carryback with no payments for the term of the SBA loan; so as the cash from buyer and seller carry back note together equal at least 10% of the purchase price.
• If a seller carryback note is part of the transaction but it is not part of the down payment, then the terms of that seller carryback note can be negotiated openly between buyer/seller/bank with no standby period restrictions per SBA (depending on the transaction, the bank may still want a standby period).
• Not only should the buyer demonstrate the ability to put at least 10% or more down towards the purchase, but the buyer should have ample fall back liquidity in addition to the down payment. Fall back liquidity is crucial to the long term success of the business since the additional liquidity adds buoyancy to the balance sheet, thereby allowing the new business owner to navigate the unforeseen expenses that are inevitable in years 1 and 2 of ownership.
• The amount of fall back liquidity after down payment is dependent on the situation, but the buyer should have personal liquidity for personal emergencies and above that inject additional cash onto the business’s balance sheet so as to have a strong working capital position from day one.
• Business acquisition SBA loans are typically structured as a 5, 7 or 10-year fully amortizing note. 10 years is the maximum if no commercial real estate is included.
• If the purchase price of the business includes commercial real estate, then the term of the note may be extended beyond 10 years (up to 25 years in some instances).
• There are no prepayment penalties on SBA loans unless the term is greater than 15 years, in which case the prepayment penalty is 5% in year one, 3% in year two and 1% in year three. After year three there is no prepayment penalty.
• A line of credit may be provided to the business in addition to the buyout term note to help fund accounts receivable and inventory.
• If the amount being financed less the appraised value of real estate and equipment is more than $250K the bank must obtain a third party business valuation. This typically costs $2,200 and takes 10 business days to complete. If the amount financed is equal to or less than $250K then the bank can determine the value unless the buyer and seller have a close relationship (such as a father and son relationship).
Credit Considerations
• The business must demonstrate the ability to service the SBA debt. The bank will analyze the prior three year-end tax returns and the most recent interim statements from the business to determine the debt service ability of the business.
• The business must demonstrate reasonable leverage and working capital ratios on the pro forma balance sheet. It is important that the buyer demonstrates a strong understanding of the day one balance sheet of the business and its implications on the business being able to meet its short term and long term obligations.
• The buyer should demonstrate significant management and direct industry experience as it pertains to the business they are purchasing. In addition, the buyer should provide a business plan clearly explaining why they are qualified to run the business and how they plan to grow the business.
• Any person that will own 20% or more of the business must provide a full, unconditional and unlimited personal guaranty.
• If there is a collateral shortfall (there often is in a business acquisition), and the loan is greater than $350K, the bank must look for additional collateral to shore up the shortfall
• If there is a collateral shortfall and the buyers have 25% or more equity in personally held real estate, the bank is required to take the real estate as additional collateral until the loan is fully secured. If there is less than 25% equity in the real estate, it is the bank’s discretion as to whether or not they take the real estate as additional collateral.
• It is ok if the loan still has a collateral shortfall even after taking additional personal real estate. The amount of collateral shortfall the bank is comfortable with is up to the bank at that time.
• The bank will most likely as the owner to pledge an assignment of life insurance in the amount of the loan if there is a large collateral shortfall and no clear succession plan.
• The borrower should look to obtain a lease with the landlord (if applicable) with renewal terms equal to or greater than the term of the SBA loan.