REPLAY: BRUCE MARKS ON SBA 7A LENDING
^[redacted] held a marathon session on the basics of US SBA 7a lending. The video is now publicly available (click above) with the transcript appended below. Searchfunder members can always review our past events by clicking on the Main menu ► located next to your profile picture or by clicking the full calendar link just above the events on the Timeline page and then clicking past events. Thank you, Bruce, for generously sharing your knowledge with the Searchfunder community. ~ ^[redacted], ^[redacted],
Thanks, Karen. I appreciate the opportunity to get to talk with you all and hopefully answer some questions that you might have. But also talk to you about how to get a deal done and how to get a deal to the closing table.
So, often times it's about the process. There's a lot of choices out there that you have. What I would like to just let the Search fund community know is, as you start your search just make sure that you do your diligence. And you find a lender who does the type of acquisition that you're looking for. There are all different types. There's SBA lenders who want collateral. I work for First Bank of the Lake; we are not one of those lenders.
There are lenders who will lend on projections. Again, we're not that type of a lender. We like to lend on cash flow. That's our most important bucket it does the deal cash flow? Do we feel comfortable?
And so, as you start your search like anything else and you look for the investors to partner with or you look for your deal team. And I know that the majority of you do that but often times I'll speak with searchers and maybe it's just not the right fit. That doesn't mean that your deal can't get done.
So, you have to be as diligent as you are about finding the right target as you do with finding the right lender. So, with First Bank of the Lake, we're a cash flow lender. As Karen mentioned, I've been doing M&A transactions solely for the last 10 years.
We at First Bank of the Lake love the search fund model. We're very comfortable with it. It's something that I understand. I’ve been doing it for many years now and am just thrilled at the opportunity that Luke and his team and Mark and Karen have put Searchfunder together. It's something that I use every single day. It's near and dear to my heart. I’m thrilled at the opportunity to be here and participate. I can't thank you again Mark, Karen, and Luke for making this great platform for people that are doing what it is that we all do every single day. And letting us come together with ultimately the goal of the searcher finding the right business to buy and then allowing him to do that and that's what it's all about. So, thanks to you for that.
Karen- Thank you Bruce for being a user of Searchfunder. I’m really curious. How did you find out about Searchfunder?
In the search fund space, obviously, there's a lot of guys from the top schools, the Harvard’s, the Wharton’s, the Kellogg’s, and the likes. So, I was first introduced to Searchfunder by a searcher who was looking for a business who had reached out to me and started to talk to me about what he wanted to do. It wasn't something truthfully that I was familiar with. I don't want to mention his name in public, but he knows who he is. He told me about Searchfunder many years ago; I think maybe three or four years ago, something to that effect.
I looked on the website and I said, “Wow, this is a great opportunity” and just fell in love with the model. I got comfortable with the experience of these searchers and what they're bringing to the table, getting comfortable with the number of investors behind them. As a lender, we always at least in our shop, we look at it, we say: “Well, not only does the searcher have to prove himself to us, but he also proved himself to the eight, nine, ten”- depending upon how many investors. We got really comfortable with that very-very quick. That was my introduction to Searchfunder.
Karen- That's wonderful! When we first started Searchfunder, there weren't very many folks at banks who had heard of the search fund model. In fact, we did a test that we just started calling banks randomly and a lot of times, I think they thought we were one of those scam artists or something like that, trying to scam them. So, it was always really tough to have that conversation. And our process pretty much mimicked what a searcher would have to go through. One of the great developments is to have folks like you on the platform who are familiar with search funds, comfortable with the model. It really speeds things up.
I can't tell you when we first started how many people talked about how they got a deal ready to go but then it took too long to persuade the lender. So, I’m thrilled to have you aboard. I’m also thrilled because we also have Live Oak Bank which is a sponsor/contributor on our platform too. They have their own search fund lending center. With both of those developments, it's a huge boon for the searcher. Finding a company to buy is hard enough, then trying to get the money to make sure you close the deal. If we can make that easier, it's the better for everybody.
So, our emphasis today is on the new searcher, sometimes we call them the search curious folks, who have heard about search or just have the inclination that someday they might want to buy a business and run it for themselves. When it comes to the lending side of search, I am probably about as novice as those individuals.
Karen- So, tell me what is a 7(a) loan to start with?
So that's just an acronym from the SBA. It’s what we call the 7(a) loan program, they have other programs, the US SBA program. They have the 504-loan program. It's very easy for a bank to participate with the SBA, it’s a one-page sheet. You sign it and that allows you to participate to do loans with the SBA. There are three levels. There are what most people know as the PLP and then there's the CLP and then there's the general lender. So, those are the three processes that one would have to go to if they were applying to, but the 7(a) program is designed to provide financing and they have set terms and conditions.
For example, they'll give you up to 25 years if there's real estate involved. They'll give you up to 10 years if you're doing a business acquisition transaction. They'll give you up to 15 years if you're doing machining equipment depending upon the useful life of that. And they'll give you working capital and those could be either five-year loans, seven-year loans or ten-year loans.
So, the 7(a) is the general program that relates to the type of financing that's included in this model. The 504 is dedicated towards real estate, the USDA obviously, that program is (and that's something we do as well at our bank) participate in. So, when most searchers are looking for a loan, they're going to be applying because we're talking about our community which is the search fund community, they're going to be talking about the 7(a) loan program which are loans designed to provide financing for up to 10 years for acquisition financing under this program.
Karen- If I starting out as a searcher, what would be your advice? Like, what documents should I get together? What should I know as just somebody who's just starting out?
In the search fund community or as you're searching for a business, there's several different ways to do it –right? You can do a proprietary search, where you're going out and you're contacting people in the space that you know. Often times, Karen, a lot of searchers will come to me and they're coming from the private equity world. So, they have a background in working in the finance business and understanding that now they want to go out and buy a business on their own. And so, they may be doing a proprietary search themselves. That's one way. Another way is obviously they use brokers and intermediaries where they're reaching out and trying to get deal flow. Another way is there's online platforms. There's several of them where businesses are listed for sale and they may want to contact those businesses.
The thing that I really want to explain to searchers is, and I get this opportunity because I speak to searchers every day. That's the one thing that I can tell you is, every day I’m talking to a searcher for sure. And a lot of it is coming from Searchfunder. --- I know I might sound like a commercial but it's just the truth --- But, we'll always talk about making sure that you're looking at the business and the underlying business and not just the cash flow.
So, when they're out there and they start their search and they say, “Oh, I looked at this business and it's throwing off a million dollars in EBITDA. I’m interested in that because that's in my set parameters of the type of deals or the size that I’m looking at.” But, when you peel back the skin of the onion, it may not be one that's a good fit for the buyer or the operator.
So, I spend a lot of time talking with the searchers about making sure that they find a business that they have an acumen in; a business that they can get their arms around; a business that they can truly wake up in the morning and say they love what it is that they do.
Because (as we know) if you love what it is you do every day, it doesn't feel like a job – right? You want to do it. And so, I spend a lot of time talking with searchers about the opportunity when they call me. They say, “I’m looking at a specific transaction Bruce and let me tell you a little bit about the business”, and then I start digging a little deeper and they really don't have the skill set or the understanding or the background.
It makes it that much more difficult so as the process begins with whether they're reaching out to intermediaries, where they're doing a proprietary source, where they're going out on their own, where they're reaching out on websites. Don't just look at the cash flow. Look at the underlying business and make sure that it's something that you're going to have the propensity to operate and something that's going to allow you to do what it is you love to do every day. That's first and foremost, because arguably, as I tell people, if you're applying for an SBA 7(a) loan, the average loan doesn't go out 10 years, that's not the average. It's more like 4 to 4.4 years that an average SBA 7(a) loans stays on the books.
But if you're going to arguably run that business for 10 years, boy you better make sure it's a business that you really want to run for 10 years. So that's the first thing, I would tell searchers is, don't just look at the cash flow, look at the business. Look at the model, how they generate revenue? Sustainability, why are they going to be here for 10 years from now? All of these are super important to get your arms around the right one. Because what I will tell you is, I speak with searchers and whether they use me or they use another lender or they don't do the deal. And I’m speaking to them 6 months later, 9 months later, a year later, a year and a half later and believe me, I have searchers that I’ve worked with for well over a year and I’m sure if you speak with the other lenders, they are experiencing the same because they're looking at an opportunity, whether they get into an LOI or not, that we'll talk about that, but that doesn't matter. Often times that deal falls out and then they're going back and looking at something else and it may be something totally not even related to the one that they were looking at before.
So, I just want to emphasize that the ones that I see that are successful -- at least on our end and the ones that get across to the finish line -- are generally those that people know what it is that they're getting into. They're not buying into an industry that they know nothing about. And that's not to say that they're, I’m sure there are a lot of those successful but for us as a lending institution, we like to see that part of the equation as well. So that's my first entree into the conversations generally that I have with searchers.
Karen- What if a searcher says, look I don't have any experience -- and I’m just gonna make it up -- in security alarm systems, something like that - but I’ve got three or four investors on my board. They've all worked in the industry. Does that help persuade you that this is a viable deal?
Yeah, it does, it does help us for sure because they're going to be relying on that board. And I think that if they can convince, like I said from a modeling standpoint, it's much easier for the bank to get comfortable with the search fund model. Because we know then our searcher not only has to convince the bank that they are the right guy but the 6 or 7 other investors. So, if the 6 or other 7 investors who have the experience are willing to bet their money on the searcher who doesn't have any experience that gives me a little bit of comfort that they know something, they see something they can provide that added expertise. And then what we will look at is, what quote-unquote transferable business skills does that searcher have that made the investors comfortable, that ultimately will make our bank comfortable. Does that make sense?
Karen- That makes sense, and then how long of a process is that from, let's say, LOI to close or to get the bank's approval, how long should the searcher expect?
Yeah, so that absolutely depends upon the buyer, is the truthful answer. We've seen deals where a buyer will enter into an LOI and have exclusivity for 90 days. And he may take that 90 days right, but it depends what's in that LOI. Often times we'll see an LOI that they want the searcher to have at least a term sheet or an expression of interest or an LOI, whatever you want to call it from a bank within 15 days. But if the searcher request in his due diligence checklist all the following items and the sellers do not give that to him in a timely fashion then that obviously delays the process.
So, a lot of times when I’m talking with the searcher and we start to actually, what I call, walk down the aisle. It's because they've gotten a certain amount of information and that just depends upon where they are in the process, but Karen a lot of this depends upon the buyers and the sellers working together. A lot of times it depends upon how much interaction the intermediary wants. I’ve spoken with a number of searchers who have said, “Oh I’m working with an intermediary, he's terrific, he's giving me access to everything I ask for”, it's very-very quick and then obviously the contrary, where a searcher will go ahead and ask for information and the buyer might not get back to him for 2 or 3 weeks and that's delayed the process.
So, it really is a process and it's hard to say, oh it normally happens within this certain amount of time. Because each deal dynamic is different and you have all different kinds of experiences. So, I know in general my answer would be, the process is predicated upon the willingness of the buyer and the seller to provide the information, so, we can move to the next steps. That's probably what I would say.
Karen- That sounds fair. I have a couple of questions and then we're going to open it up for the ones in the chat. These are questions that are fairly common that I get. Do you have to be a US citizen to get a 7(a) loan?
No, you can be either a US citizen or have a legal permanent residence status. So, you must have a green card and have the eligibility to be here. Now, I recently had a training a call from a searcher and the comment was as well, I’m not a US citizen and I’m not a legal permanent resident but I’d like to buy a business in the US. Well, you can partner with somebody and as long as that partner has 51% ownership and is a resident or a legal permanent resident here in the United States, then that applicant would be eligible for, at least to apply. So, if you have a visa or an E1 or an E2 and you want to apply for an SBA loan you would not be eligible to do so.
So, you can partner with somebody or bring on somebody that does have that status and partner up with them to apply for an SBA loan. A little piece is better than nothing.
Karen- And do you have to buy a US business with the loan?
Yes, you have to buy a business that's filing US tax returns, that's a must. The SBA does not want to lend money and have that money go offshore. So yes, the business should be located here in the United States and be paying US taxes.
Karen- What are the size limits for that type of loan? How much can you get under the 7(a) loan?
Well under the SBA the maximum is 5 million dollars, under the SBA program. But we've closed loans that have been much larger than that. It just depends upon: will the buyer and the seller bridge that gap? There's also mezzanine lenders that are out there. There's also, the bank can do a second piece conventionally behind the SBA so we could do a 5-million-dollar SBA loan and do maybe a million-dollar conventional loan to look at deals that are in that 9-to-10-million-dollar space. But I generally play with deals that are sub 10 million dollars because that's the space where the private equity world starts to look at. When deals are approaching the 10 million dollars mark, you're inviting a lot more competition and a lot deeper pocket, if you will.
So, I did close a 10 million deal in June, it was a great business, and we were able to get it done with a 5 million SBA loan but 5 million under the SBA 7(a) program, per guarantor. Because a lot of times people say well, I have a partner, can he get five and I get five. It's five million dollars per guarantor is the max.
Karen- That makes sense. Are there any special considerations when a loan is being evaluated for women or people of color or women-owned businesses or businesses owned by people of color minorities?
Well, there's in each state and they have different minority programs, and they have smaller loan programs. But the SBA 7(a) if we're talking about the search fund community, it's based upon the cash flow, it's based upon the deal, it's based upon the structure in deals of this size. Although the SBA Form 1919 does ask those questions, just for information purposes. But what people need to understand is, it is a guaranteed program, it's the banks that are making the loan. So, it's the bank's decision, whether they want to make the loan or not. And each bank, and this is also what I want to make sure that I state to the community out there that each bank is different, and each bank makes their own lending decisions. There are rules I call the SBA, the umbrella if you will. So, that's the canvas covering the top and then you have all the little spikes underneath holding up the umbrella, I call those the banks. And sometimes this one is broken but the umbrella still stays up. The SBA has a SOP[redacted]which is the new version that is effective October 1, 2020. And they lay out the rules and the regulations which the SBA lenders must adhere to.
But each SBA lender in reading that rules and regulations may interpret things differently, it's just the way it is. So, one bank may look at it and say we're going to do it this way and another bank may look at it and say no we're going to do it this way. Even though we're all playing under the umbrella if you will of the SBA, there are certain program requirements like a personal guarantee. That is a program requirement, how much money you have to inject into the business? That's a program requirement. So, there's certain things that are program requirements and I’ll just give you one as an example. Often times people will say, oh I’m buying a business and I understand from the SBA that you need a lease to match the length of the SBA long term, so I need a 10-year lease. Well, that's not in fact true. It's a guideline by the SBA, but if the business's occupancy of that space isn't conducive to the success of the business, then you don't need a 10-year lease.
I'll give you an example, I had a loan which we were working on closing, it ultimately fell apart. But they had 2 locations and one of the locations was on a month-to-month lease, but they could go across the street and run that business doing the same exact thing. So, we were fine with that because if this landlord didn't want them, there was a lot of different spaces available to them where they were at that they could just go and lease.
So, when the searchers are out there looking and they're talking to the individual lenders and when I talk with searchers, they're like, “Great Bruce, I appreciate it, I’m talking with two or three other lenders”, which they should. Each one of them looks at things maybe a little bit differently. And it's up to the searcher to ultimately at the end of the day decide who they want to walk down that aisle with? Who do they think has the ability to get their deal closed? And who's going to come through for them? Because obviously that's the name of the game. And we've got a very successful track record as a number of lenders that are on Searchfunder do. We've got some great lenders on Searchfunder, no question about it. And at the end of the day that's what it's all about, is making business happen for everybody. There are tons of business to go around, that's for sure. And I’m the first one to say, talk to as many people as you can, and if I can help, terrific, let me know.
Karen- Thank you for that Bruce, I appreciate that plug for your competitors. One thing that I really value about the search fund community is the camaraderie that we have that people share information, they share knowledge and although I’m sure you are a very competitive person, it's not a hostile competition.
It's not, we talk about it. We all know who is playing in this space. There are some great folks in the space, but truthfully Karen we've got a lot of business out there. I’m very blessed, more than my share I want to say. But there's a lot of us out there, it's funny because I just got a 5-million-dollar transaction approved and I got it referred to me by another banker. And he said to me “This is a very good deal Bruce; I just can't get it done at my bank, but it's a very good transaction.” And we got that deal done from start, and to answer your question, before, because the package was ready literally, I got the package on the Tuesday the following Friday we issued a commitment letter. So, we had the loan for eight days and we issued a commitment letter. And it's now in closing and we expect it to close in the next couple of weeks here. And that was referred by another SBA lender.
Karen- So, this is terrific! So, I’m going to turn things over to Mark, who has been watching the chat, I’ve seen a few questions pop up and Mark, are you ready to ask a few?
Mark- Yeah sure, so let me just read off some of these questions in the chat here. And so, I guess we'll start from the beginning if that's okay with everybody. So, Bruce, Noah wants to know if your plan is to acquire multiple companies, is there anything specific to consider with respect to the SBA?
I don't want to say with respects to the SBA, because again if you're a searcher and you're gonna buy, let's say three businesses and one of them is in California and one of them is in Boston and one of them is in New York, obviously, that's going to beg the question of how are you going to run all three right? So, if they're all internet-based businesses that's a different story, right. What's going to be the structure of them? How are each one, if you're buying three different businesses or two or four, doesn't make a difference. Are the sellers on board for each one of those transactions to happen at the same time? So, you can borrow like I said up to five million dollars per guarantor. You can apply for a loan and then if you close that loan and you want to apply for another loan, you can do that. The SBA doesn't limit the number of times that you can apply. So, there's different questions and different dynamics Mark, that comes with buying multiple businesses. But the SBA when you read their regulations, doesn't say, “No you can't buy one, two, three, four businesses” to properly answer that question.
Mark- All right, thanks for that. I think the next question is from Robert who says, what is the guarantor structure for a traditional search funded deal, is the searcher the one who's guaranteeing 100%?
It depends, the rule with SBA is that anybody who owns 20% or more of the borrowing entity must personally guarantee the loan. So, I closed a search fund deal a month and a half ago in the Texas region and we had two guarantors on that deal. So, it just depends upon what the ownership structure is? But you must have one guarantor, you must. And anybody who owns 20% or more must personally guarantee.
Mark- All right, so I guess that makes sense. Does that mean that if another 20% owner is in on it, and this is my own curiosity, that it split like[redacted]in terms of the total guarantee amount?
No, they would both be guaranteeing the loan amount.
Mark- Okay, I see. Do banks take a second mortgage or lean on equity of your own home? As like a homestead protect in states where there is a homestead protection like in Texas?
So, in Texas we cannot, because it does have the homestead. So, we do a lot of transactions in Texas and we cannot take the searchers home. If you're not in a state bound by that, there's a rule about equity. But again, if you read the SBA SOP[redacted], it will tell you if there's insufficient assets to adequately secure the loan with the business, then the bank SBA must look to the personal guarantors and any assets they have to make the shortfall, that's what it says in there.
Now, there's also in there that the SBA doesn't encourage lenders to take a second mortgage on property if there's less than 25%, that's what it suggests in the SOP. Can a bank do it? Absolutely! Like I said before, each bank interprets the SOP a little bit differently. So, if we think that there's an opportunity for that, there's 20% equity in that piece of property and this is a 10-year SBA loan. And what's the likelihood that that equity is going to increase by 5% over the next 10 years? Probably a good bet, then to more securitize ourselves, we may take the home as additional collateral. I want to just touch on that for a second Mark, if I can just explain, I am very fortunate to be and I tell people experienced enough and I’ve said this to Karen, not old enough but experienced enough to have been formally trained by the SBA. So, when I did my training in[redacted], I would literally go down to the SBA district office and get trained.
I understood and learned why the SBA does a lot of things that they do, and why they think that the way that they do. And the thought behind that, and I want the search fund community to understand this is that the reason the SBA suggests that you take equity in a home is because their feeling is if the guarantor is not willing to do that and stand up and assume that this loan is going to be really good and make it, then why should they? That is literally their thought processes. If we're willing to lend you five million dollars and you're not willing to provide a second mortgage of a hundred thousand dollars on your home, why? Maybe we should be looking at it a little bit differently and sometimes that's the disparity.
A lot of my deals I will say 95% of my transactions, we have a collateral section that we do a write up on and mine never changes. It just says an N/A, not applicable because the searchers don't own a home. The real estate is not going to make a difference whether we do or we don't do a deal. But the SBA's thought is if you have it and it is available, then the borrower is committing himself and his assets to the success of that business and ensuring that commitment by allowing the pledge of the collateral. A very technical answer but I wanted to make sure I let everybody understand the why. It's not just giving an answer but it's understanding why you're being given an answer.
Mark- Thanks Bruce. Somebody asked why can’t search fund investors avoid a personal guarantee when they own over 20% and I think this is in reference to traditional searchers. So, let me just answer it really quick. Traditional searchers do not use the SBA. They're more sort of private equity backed sort of structures and those investors who have like private equity funds or family offices typically don't go through the SBA to get those deals done.
That's right, but it's interesting because I work with a lot of, and very close with a lot of those family offices and those family offices get debt its they lever up as well. That's how they got a better return on their investment, but they've got such good relationships and you don't know what they're backing that money by. They may have millions of dollars in that bank or millions of dollars in their wealth management and they're getting a loan against it. So, they're not utilizing the SBA program for sure but that doesn't mean that they're not getting debt. And there might be something behind that as well because that's what a lot of small cleaning offices do.
Mark- James, wants to know as a US citizen with a local business could I use the SBA funds to buy a business outside the US?
No. Mark that last question's a very good one, and I want to just expand upon a little bit about that. A lot of times searchers will say well we're setting up an LLC. And this is going to make sense or we're setting up this corporation and this corporation's going to be an owner and then this corporation is going to be. The SBA always goes back and pierces any veil, or they unravel that layer of the onion down to the core. And that core is what is the use of proceedings funding?
So, on the last question the reason is you may have a US-based business but if you're buying a business outside the US that doesn't pay US tax returns and those funds are leaving the US, it's not eligible. Just like if you're setting up an LLC and that LLC is now going to be owned by two different corporations and believe me, I’ve seen it. They're rolling back and they're going all the way back down and going okay, who owns that? Who owns those LLC? Okay, who owns those? What's the percentage ownership? Oh it's 50-50, both you are going to personally guarantee. So, you use the proceeds and how money flows, is always very important with the SBA. And they also, I’ve seen with searchers and investors, where a big thing of keeping the guarantee for the lender is that the investors when you're going out to your investors you need to know this. You have got to provide evidence of where that money is coming from and you must provide two months’ worth of bank statements supporting that.
Let me give you a quick example please, I had a deal for a searcher, one of his investors was extremely wealthy. One of his investors said because I’m so wealthy, I have my money in a trust, and I do not want to show you my trust statements. But I will get a certified statement from my bank and the trust officer that I have money for this investment. That was not good enough and the searcher ended up not using that investor and going to somebody else who could provide two months’ worth of bank statements to prove where the money came from.
I just had an opportunity where, a searcher called me and said, “Well the money is coming from overseas, I have a foreign investor he's an investor, is that eligible?” Yes, it is. Where is the money coming from overseas? What country? We have a set of rules that we have to follow. The money was coming from Iran. Not eligible, we do not do business with people in Iran, we are not allowed to. He could not use that investor because the money was coming from Iran.
So, when we get into a lot of these little technicalities and there are with SBA lending it is the best tool out there, by far, far enough for searchers to get money to buy businesses. But a lot of times there's a lot of other little nuances if you will, that you have to make sure you follow to make sure. But I want everybody to know if you're getting your investors lined up and you're making an acquisition and you're using an SBA loan, your investors must provide two months’ worth of complete bank statements, not just balances that will be required to evidence where we have the Patriot Act. So, just wanted to make sure, sorry about that, I just felt that was important Mark.
Karen- Thank you for that clarification, that's really helpful. I have a private question from someone, and they ask, are you allowed to have debt that is junior to the SBA loan?
Absolutely! In fact as a lender we love it if they want to have depth behind us? Great, gives us another out guard, God forbid something happens, maybe they'll have to protect themselves by taking us out. So absolutely allowed, yes!
Mark- Lawrence, wants to know what's the maximum amount of leverage that is allowed or if there's any hard and fast rule to it? I guess.
I want to make sure I answer this correctly. Different banks again, look at each deal differently. And when we talk about leverage, we talk about debt service coverage. In the SOP, if you open up the SOP, they talk about debt service coverage at[redacted]Our bank wants[redacted]I know there are some banks that want 1.5 times, right? Then depending upon certain mitigants or certain strengths to the deal, those numbers are going to fluctuate. So, from a leverage standpoint it just depends upon what the cash flow is? Cash flow dictates the leverage, it dictates how much of a loan you can get from the SBA. It will dictate the terms and the conditions of the seller note.
I get a lot of questions about, well talk to me about what the seller can hold? What are his terms and repayments? Is it a 10-year loan? Does it have to be on standby today? No, those were the old rules. But I am very consistent with the statement that, cashflow will dictate the terms and the conditions of the loan and that loan being my loan, or a seller’s note. I’ve had seller notes where they've been on two years, I’ve had seller notes been on five years, I’ve been on seller notes on 10 years, it just depends.
So, from a leverage standpoint, I don't want to answer on behalf of all the banks out there, Mark, I will just say in our particular instance it comes down to debt service coverage. We want to see a one and a quarter time for the last two years. The leverage will determine what that looks like based upon all the factors, the investment, the debt, the seller held note, and the like.
Karen- Speaking of the seller, what happens if a seller wants to stay on as an employee or a consultant? Do you look at that more favorably or less favorably or does it make a difference?
Yeah, so contractually a seller cannot roll any equity, that comes up a lot. And contractually cannot be on or stay longer as an employee or a consultant for more than 12 months. So contractually they can't stay on for 12 months. I'll share a story because stories are often nice to hear, it's not a great story by the way but it's a story, I want to share it anyway.
I was working at a bank, another lender had made a loan, it was an SBA loan. The seller did not take any notes. The buyer put in 20%, bought the business, got an 80% loan with our bank. And at the end, when the loan closed, the seller claimed to have had deal fatigue, and wanted a couple of weeks vacation. He took the couple of weeks vacation but I guess that couple of weeks turned into forever, because he never came back. That business was out in 90 days. The guy who bought the business lost the business because he bought a business that he really did not know anything about it. He didn't have a propensity for the business and that's how I opened up my remarks to you Karen, was, making sure, so it's kind of like if you play with fire and you got burnt you really don't want to play with fire again.
So, it's that kind of mentality that you think about and why loans go bad? And listen, if a searcher is putting his life on the line, they're young guys, ladies generally, they're just coming out of either the private equity world or their school, they're in their 30’s and they're out there and they're now going to personally guarantee. The last thing you want for them as a lender and the last thing that they want is for the deal not to do well and for that to have happen and it was sad. It wasn't a search fund deal it was just an acquisition of a smaller business but none the less.
The SBA's mentality and I want to go back to my training at the SBA to again explain, why the SBA has this rule in place? People say, okay I know it's an SBA rule that the seller can't stay on for more than a year, why is that? I’m going to tell you why? The SBA in lending to the searcher or the buyer or whoever is the acquirer of that business, the reason they are lending to you is they want you to run that business. And they think that a year's time is enough to transition, to allow for that to happen.
They don't want Sally, who's been an employee for 20 years, now going well Mr. Johns is around the corner and I’ve been answering to him for the last 20 years and he does it this way and I know you're the new buyer and I don't want to do it your way, they want to avoid that. And the SBA's thought process is, after a year that should be certainly sufficient time for any transition to occur.
Obviously if there's a second tier of management, that allows that seller to be out quicker, great even better. Those businesses get a little bit higher of a multiple because they do have a second layer of management. So, the thought process behind the seller not staying on for more than a year is in the SOP. But the thought process behind the why is, they are lending to that person to buy that business and they want them to operate the business and make it their own and that's why.
Karen- That's wonderful. The next question in the chat is probably an excellent one with that plug for our future event and that is, what in your mind Bruce should a searcher look for in talking to a banker and how do bankers differentiate themselves?
It's a great question and one I appreciate. As you go through your life cycle as an SBA lender or a banker. There's a lot of banks out there. There's a lot of banks that do SBA lending right, there's thousands. Putting myself in the Searchfunder’s shoes if you will, I want to make sure that I’m talking with somebody that has done this before who has walked down the aisle and who has gotten to the closing table. I think that as you talk to the lenders you will very quickly get a sense of who that is? And who has that experience? And what their track record is of success? And what I always tell people is, successful people want to do business with successful people. That's just the way it works.
And it's one thing to say, I like your deal, I think I can get it done. And there's another thing to say yes, I’ve closed 25 of these transactions in the last two and a half years or whatever that number is. I think we all have experiences in our lives with dealing with both successful people and unsuccessful people.
Whether it's working with a banker or just working with somebody who's going to build a cabinet and know whether he has the experience to do that. Show me your work? Or if they're catering a wedding, I’m thinking of that because my daughter's getting married. And we were out talking with caterers and you would say, okay how do you differentiate yourself? It's very clear to see the ones that can. And a lot of times it comes down to a relationship, right? Its people liking who they're doing business with, so that's a big part of it.
So that's why I said at the beginning, yes, you should do your diligence and talk to as many bankers. But it's kind of what I think of Karen is, if I want Chinese food for dinner, I don't go to a pizza restaurant, right? I’m gonna do my due diligence. I’m gonna look online. I’m gonna do the background checks and find out if I’m looking for a lender who can do a 5-million-dollar good will SBA transaction. That list is not this long, it's this long. There's only a handful of lenders out there that are doing that. And the people on this call and the people in the search fund community, they know who that is. Because when I ask who are you talking with? I get the same three or four players every single time, right? Because there's not money though.
If you're doing an acquisition and somebody calls me and says,” Bruce I’m buying a business and I need a million-dollar loan”, I’m the first one to say here's three or four banks in your area that I think would be a great fit. Because for a deal that size, it makes sense to go to a local bank that participates with the SBA. That they can bank with, that they can grow with, that they may need to get their home mortgage with, that they may need a car loan from. That's a perfect space, that's not the space that I play in, right?
So, it's a great question. I would answer that sincerely by saying, talk to as many but do your diligence up front. Narrow your list for the space that you're buying in, and you'll come across the right person.
Karen- Thank you. Thank you for that.
Mark- From your experience Bruce, what default rates do you see among searchers? And if they do default due to sort of like unfortunate circumstance, I don't know like COVID-19. Can they then apply a new loan for a new acquisition assuming everything was above board or is your credit sort of like ruined forever?
What a great question! Thank you for asking that. I have not had any searchers default on any loans that I’ve made, so I can't tell you statistically. And I’m thrilled to say that, for not only my experience in this space and I’m not talking about just my experience here at First Bank of the Lake. I’m talking about my experience at my prior employee that I was at almost four and a half years. And then the bank before that. So, I have not had anybody in the search fund space not be successful.
But I will tell you, if God forbid that happens, if you default on an SBA loan, you are not able to get another SBA loan. So, if the government has taken a prior loss let me put it that way, if the government is taking a prior loss, if you made the SBA hold, if you lost the business and you were able to successfully pay off that SBA loan, so, the SBA loan the SBA or the government did not take a loss, then at that point it would be up to the lender. Because there are questions that you ask to determine if they want to proceed with you. But you cannot apply for an SBA loan if you've had a prior loss with the SBA.
There's a thing called cavers which we run on each applicant and that gives us a history. We had a deal where a gentleman had a loss on an FHA loan and the government took a loss and he was not eligible to apply for an SBA loan. So just interesting for you to know that it goes across the spectrum of any type of government debt. If you've had a student loan and you defaulted on a student loan and the government took a loss as a result of you not paying on that student loan you would not be eligible to apply for an SBA loan.
Karen- I’m going to skip one or two questions that seem to be more advanced kind of down the road questions. Hopefully, we will bring you back Bruce for searchers who are further down the road. We're going to just focus on the beginning searcher, so the question I have is, if I use friends and family money to cover 10% of the acquisition will they have to also disclose two months’ worth of bank statements?
Yes, absolutely. So, we had a deal where part of the equity was coming from his father and he was giving a gift letter. And even though we had a gift letter that said, it's a gift, we still had to get two months’ worth of bank statements showing where the money came from. Again, it goes back down to, follow the money, where did it come from?
And I recently took a class as part of continuing education through NAGEL, which is the National Association of Government Guaranteed Lenders, and they had a whole specific class on making sure that the equity and where the money came from does not kickout your SBA guarantee. It only comes into play obviously if the loan goes into default. Now we've got to go back, and we've got to ask the SBA for that guarantee care. But that is one of the very first places if not the first place that the SBA looks to is, and if it happens within 18 months it's called an early payment default. And that is more scrutinized. So absolutely they've got to provide two months’ worth of full bank statements to support either, their investment, their gift whatever you want to call it.
Mark- So I think in sort of the same vein that Karen is trying to push here, as we are sort of nearing the close of our time limit, I’m gonna focus a little bit on more sort of generic questions that probably have a broader appeal. And if you guys want, feel free to reach out to Bruce on Searchfunder or wherever and I’m sure he'll be happy to answer your questions. But I think this is something that everybody is interested in, just from your experience, what are some industries that are having success getting SBA loans approved right now? And what are some industries that are kind of struggling?
So obviously e-commerce businesses are doing well. And we do lend on e-commerce businesses. So, we're finding those that are doing well. I’m just going to go back and think about the deals that I’ve seen that are doing well. Technology-based businesses are doing really well now. The whole advent of the workforce moving more towards a home-based business. Technologically those type of businesses providing those kinds of services are doing well. I’ve done several commercial contracting type businesses, infrastructure type businesses, where a lot of it is getting government money those businesses are doing well.
The things that you want to stay away from are the sensible things. For us, everybody says, what is it that you do? And what is it that you don't do? We're pretty industry agnostic, but things tied to residential real estate or residential construction or residential service, it's tough. That's a tough business to lend into, obviously, brick and mortar, very tough business to lend into. We're not a huge fan of apparel-type businesses.
So, what we look at, when I have conversations with searchers, Mark and Karen, a lot of it's relative to the business, the business model, the sustainability of the business. Where we see the business going? And hopefully lending to those right businesses. There's a lot of good businesses for sale. It’s just, make sure you select the right one. We don't look at it and say, “Oh”, we try to again, pierce down find if the business is sustainable, find why it's a good business model? Find, why we are comfortable that this business is going to be around six to ten years?
I always tell the searchers we're in the 99% business. We've got to be right 99% of the time. You don't want to be wrong. You just don't want to be wrong.
Karen- So what happens if you end up in a situation where you have that 1% business? A searcher acquires the business, something happens that's not foreseeable when they buy the business, they're down the road a little way and they're having trouble servicing the debt. Are there opportunities to work with them on the debt? What happens?
The answer is yes; the SBA does have strategies which allows the searcher to provide time to hopefully build back the business. So, the SBA allows you a one-time 90-day deferment on the loan. So technically what would happen is they would say okay for the next three months you do not have to make a loan payment and you can retain that cash flow. And we'll just extend the life of the loan three more months. And then you come back, and we provide how that business is done and hopefully get it back on-track.
If the loan does go into default and listen, loans do go into default, for sure. You want to work with the lender as best you can, to see what you can do? And it depends upon the size of the loan. But just avoiding the lender, avoiding the calls, not assuming that bankruptcy is ultimately going to protect you, which most people then file bankruptcy and that protects them to a certain extent.
But it's a government program. So, if you think about the consequences of defaulting on a government loan and then asking for something from the government down the road, hint, hint, refunds on tax returns and other things, they're not going to be so lenient to do that. So, yeah but there are strategies which the lender can work with you on, God forbid you get into trouble.
I remember lending to a searcher; he bought a business. About 45 days after he bought the business and it was in the healthcare space, he got a letter from the state saying that they weren't in compliance with certain filings and that they were going to stop him from doing business.
He had a very large rep and warrant, and he went back to the seller and said, “Do what you have to do, because you didn't do it beforehand and you're going to put us out of business. And not only is your seller note in jeopardy, but my business is also in jeopardy. My SBA is in jeopardy and my livelihood is in jeopardy.” And they were able to rectify the situation and get things back on track.
And so, I’m a fan of a seller note. We could do another session on pitfalls I’ve done. Anytime you want to do that character the war stories. But I’m a big fan of obviously a seller held note for that reason because it does give the searcher leverage as well when it's needed. But to answer the question, you absolutely want to work with your lender as much as possible, God forbid you get into that situation.
Karen- Thank you for that, and maybe one more question Mark, before we close it out, and we will bring you back and I love the idea Bruce of doing war stories, I love it.
I could do it, not all bad story but…
Mark- I guess to close it out, we'll go with a really high level one. There is the availability of 504 loan versus the 7(a) and could you speak a little bit to whether 504 would ever sort of be applicable in this situation?
Sure, 504 loans are not for business acquisitions. So, it's for the real estate. For example, I got a transaction yesterday. It was an acquisition of a business for 5.9 million and the real estate was going to be 1.9 million. So, the real estate can be treated as a separate 25-year loan with a portion of that fixed for that 25 years through a 504 loan program. But the 504 loan program is specifically design marked to lend for equipment in real estate not business acquisition. So, the 504 would only be applicable if the acquisition included real estate in the transaction.
Mark- I see. So a lot of searcher deals, they have a fairly, well I wouldn't say a lot but some searcher deals have a pretty heavy like asset component, so you're saying in certain transactions the acquisition will be funded in part by 7(a) and a combination of 504 which could put you over like the amount limits for each one right?
Yeah, for those that have stayed on I'll mention this, I had made a loan to a searcher a couple of years ago. He bought a business in the Orlando, Florida area. And the loan was 4.9 million dollars. When he was buying the business, it had some real estate and we talked about it. And I am a little prejudiced. I am not a fan of real estate; I’m just going to put that out there so take these comments with a grain of salt. But I said to him, “You're buying a manufacturing business, you haven't been in there day one. You don't know if the real estate is too big too little or whether you're going to be there or want to move two or three years from now you just don't know. Sign a contract to buy the real estate with an option”. “Okay, I’ll buy the real estate in a year or two”. Real estate doesn't make you money, it doesn't create cash flow. It's just an asset that you're financing. He said, “Okay Bruce, I’m not going to buy the real estate”.
Fast forward, I talked to him six months later, he expanded a second shift, he had to rent space across the street. He had totally outgrown the real estate. He said I’m going to be calling you in the next 30 to 60 days. I’m looking to buy a[redacted]square foot facility and I want an SBA loan. Well, he got a 4.9-million-dollar SBA loan. How are we going to do another SBA loan? So, he signed the contract to buy the real estate. I said so we're going to do what we call an SBA 504 green loan, g-r-e-e-n, that allows you to borrow up to 16.5 million dollars more in addition to your 5 million guarantee. By the way for real estate and equipment if you can show especially with the real estate that you have a 10% cash flow improvement, how can you do that? By putting in LED lights, he had a lighting background.
There's a company that comes out there, they do a project survey of the real estate and the improvements and whether you're gonna save this 10%? He hires the company, comes through, we lent him 4.5 million dollars more to purchase the real estate under a 504 green loan program. So, we got a 4.9-million-dollar business acquisition loan and then I made him a 4.5 million dollars 504 loan, green program to buy the real estate.
When people are buying real estate on an acquisition transaction, again, I’m prejudiced, I’m not a fan. Because you don't know what you don't know, right? You don't know whether that building is too big and maybe you're paying too much rent, maybe you want to move, maybe it's not enough space, maybe you want to expand. It depends upon the type of business that it is Mark but to set there is a difference and you can use a 504, there's different strategies for both. But the 504 is geared towards equipment and real estate and the 7(a) towards the acquisition of the business.
Mark- All right, thank you Bruce. I guess Karen back to you to wrap up.
Karen- Thank you Bruce for answering all of these questions. It was great! I learned a lot today, really appreciated it. What I’m going to do now is I’m going to stop the live stream and we will stay on board in case folks have questions about Searchfunder, more questions about the 7(a) loans that we couldn't do today. We'll stay on for another say 10 minutes or so if folks like and I understand that we went long so if you feel like you need to jump off also jump off. Thank you everyone for your attendance.
Are there folks who have questions? It looks like most folks are poppin’ off. This is wonderful. Bruce, I really appreciate it.
Oh yeah, well, thanks for the feedback. I hope everyone else thought it was good and be interested to see what transpires.
Karen- So I do have a question that came in on the chat quickly. Any nuances around securing working capital lines of credit for a business that is acquired with a 7(a) loan?
Yes, so we will provide working capital. A lot of times working capital is built into the acquisition as well. So, when I'm looking at an LOI or a draft purchase agreement, I always look to see if there's a peg working capital number in there. If there's not, we'll talk about what the needs of the business. We ask for a cash flow model. That cash model will dictate how much working capital a business needs. And if it's not built into the purchase price of the business, we will provide on top of that, for a loan. We can do it inside the loan if it really needs to be term financing, if not, we can provide an SBA express loan up to $350,000 for additional working capital.
But what I always tell my folks is, need determines the amount and use. So, if you build that cash flow model, that will tell you specifically what you need? Don't pull a number out of here and say, “Oh I need $200,000 for working capital”. “Well, how did you get that?”.” Well, I just want to leave cash on the balance sheet”. “Why?”, “Oh just in case”. “Okay, what if you don't need it?”. “Well, but I want it just in case”. So, that doesn't work, right? So, it's gotta be need determines the amount and if you build that model, we’ll give it to you if it's not into the price of the business.
Karen- And the next question is that do you have searches who use the rollovers as business startup ROBS along with the SBA loan?
The answer is yes. A lot of times in the SBA[redacted]which is affective, October 1st ,they came out with a new strategy around ROBS that is as long as it is a single payer the loan cannot be processed by the lender, PLP. Prior to that, we had to actually go to the SBA and they had to review the plan to make sure that it will….. with ROBS, for sure.
It's a great strategy to fund your transaction and not have to pay the tax consequences that go along with it. The cost of setting it up is about $5000. There are several companies out there, and if that person wants any more information, I certainly would be happy to share further. I definitely have done it many times.
Karen- Can you give me kind of an overview of how that works? Are they taking money out of their retirement account to help fund the business?
Yeah, so what they do is, they set up a qualified plan with the IRS and they take the money out of their 401K and they set up a Corporation. The funds are transferred to that Corporation, tax free and then that Corporation makes the investment. So, the Corporation must at least own a certain percentage of the business because the Corporation is actually a borrower. That's the mechanics of how it's done, and then every year you just have to make sure that you're submitting the proper paperwork to make sure that you stay in compliance with your plan.
Karen- If there will be any additional questions, we’ll give them one more minute, in case somebody has something else, we still have a good number of folks on the line, remaining, so just in case.
So, it looks like the comments came back pretty good. We got some good comments, which is nice. And so, for those still on the line, thank you. I appreciate the opportunity. I'm on search funder. You can always reach me on there. Karen has my information as does Mark and Luke.
Blake- Great session by the way! I agree with everybody and the comments says that it's great! I know we're leaning towards kind of newbie questions, so maybe this one is a good newbie question. You mentioned that past the LOI stage, when a deal comes across your desk, you can do all the diligence you need to do and get the funding pretty quick. Would you say there's any advantage for searches to contact you earlier than that? So, you can get to know them, they can get know you. Figure out what kind of deal terms you like, or do you like them to just come in at the end when there's already a firm target and the deal is very far in the process?
Yeah, great question Blake. I am happy to start the dance at any time you do. I get called in a lot before an LOI, a lot of searches want to see if they're gonna get financing? You know, when you're dealing with an intermediary, and you’re a searcher if you've started your search, you'll know that they'll say, well, I have to feel confident that you're going to be able to obtain the financing. That's what you're going to find a lot of because the intermediaries want to bring qualified buyers to their sellers. I always tell the searchers is, don't lean on the intermediary, he's not representing you. He's representing the seller. His interest is the seller, the seller is paying him. So, I can be brought on as quickly as you want to, a lot of times searches will call me and say, “I want to get somewhat of a pre-qual Bruce or a letter of interest from you that will show the intermediaries that I've done some due diligence. I've spoken with the lender that I know; I'm qualified to buy a business of this size.” Now I've done that many-many times Blake. So great question. I'm available and ready to help whenever you want to bring me into the deal, truthfully.
Blake- Great thanks and one quick one as a follow up. You mentioned that if a searcher doesn't have experience that quite fits with the underlying business that they're looking to acquire. You mentioned that if they've got, 7 or 8 equity investors who are pretty committed, that helps increase your confidence in the deal. For those equity investors, are you looking for a similar thing that you mentioned? Some kind of letter of interest or are you looking for committed capital?
A lot of times it's not committed capital, but a lot of times the searches don't want waste their time or my time. So, a lot of times they'll come in and say I have letters of interest already or I have people that have said that they'll support me because you're not going to go out and spend hours on hours and days and days and months and months, get a deal and then not have capital behind you so. I find it very infrequently that if a searcher calls me up and we start walking down the aisle that they'll call me up and say I can't get the deal done because I don't have the money behind me that truthfully like that is not happening yet. I have not had a deal since I started this model several years ago. Started lending in this model several years ago, where I’ve had a searcher call me up and say Bruce, I just can't get the deal to the table because I don't have investors behind me, that's not happened.
Blake-Awesome, thank you. It's just this kind of chicken and egg problem that independent sponsors and non-PE folks deal with.
That's why I made the comment before that the searcher, if he doesn't have experience and now, he's going to go out and buy a business that he doesn't own, he's now going to convince 5,6,7 depending upon the number of investors he's gonna get that he is able to do that business. That gives us that much more confidence. That's why I said that normally that will be very sustainable for us, because if he does get the community capital, that people that are frankly a lot smarter than me and have a lot more money believe in the searcher and are willing to back him. So, that speaks a lot to the searcher and our bank understands that it is willing to proceed with that.
Karen- So one last question, which is in the chat, it's got some acronym in there, so I hope that you know what this means. From a ratio covenant standpoint, you mention your focus is on DSCR as a cash flow lender. Any other ratios of focus, fixed charge, leverage, etc?
So with SBA, these are SBA documents and so you're not going to get covenants in an SBA document because they're not there. So what covenant Karen is, is what the searchers you’re speaking to is, are there other requirements that the bank has that must be met from a financial perspective in order to maintain the loan?
The beauty of an SBA loan is, it is a 10-year loan. We make it and it's just like a 10-year car loan. Hopefully, you make the payments every month. If you don't make the payments, then that's when things are gonna start to get in trouble. But we're not going to come to you and look at it and say, oh your current ratio is at 1.5 to one or your quick ratio is at one point you know there's not going to be fixed charge covenants and things of that nature with an SBA loan.
The only thing that they will do is if this seller is holding a note and the searcher is missing payments with us, we will require him to not pay the seller as well. But that's going to be part of the documentation, but to be specific to that question, no, there are no other fixed charge ratios of coverage ratios or covenants that go along with an SBA loan.
Karen- So that is our last question. You definitely did the gauntlet Bruce, really am grateful for it. Thank you so much. Thank you for your time. Thank you everybody on the line. Feel free to message Bruce through Searchfunder and get in touch with him. Thank you everyone. Well, we will close out now.